In other words, if MBIA was required to make payments on just 0.2 percent of the nearly half a trillion dollars of bonds it had insured, it risked losing its triple-A rating.
By the time Ackman met with Mark Gold, who oversaw MBIA’s structured finance business, it was nearly 7 p.m. The fund manager from Neuberger Berman was long gone, and the building was nearly deserted on that summer evening. Ackman talked with Gold about the company’s business of guaranteeing collateralized-debt obligations (CDOs), a business that Budnick described as “booming.”
CDOs were Wall Street’s favorite new asset class. The securities are built out of pools of securities rather than pools of loans. Otherwise, CDOs work on the same waterfall principle as simpler asset-backed bonds. MBIA was backing lots of CDOs at what it called “super-senior levels,” the most senior or highest levels of a CDO securitization.

…

Although the company never disclosed what assets it funded through the SPVs, Gotham had been able to identify about half of the $8 billion in loans. Companies selling assets to the SPVs included Onyx Acceptance Corporation, which made loans to credit-impaired borrowers to purchase used cars, and American Business Financial Services, a company that originated home-equity loans in the subprime market.
Gotham also pointed out that MBIA was now entering into credit-default-swap (CDS) contracts as a way to guarantee collateralized-debt obligations (CDOs), despite a New York state prohibition on bond insurers backing derivatives. “LaCrosse transforms obligations that MBIA cannot guarantee directly into ones it believes it can guarantee indirectly,” the report said. A statement in MBIA’s most recent filing with the New York State Insurance Department, saying the company has not entered into any transactions classified as derivative instruments, “obscures the company’s true credit derivative exposure,” the report said.

Until it all fell apart in such grand fashion, turning some of the most prestigious companies in the history of capitalism into bankrupt beggars, all the key players in the derivatives markets were happy as pigs in excrement. At the bottom, a plethora of aggressive lenders was only too happy to sign up folks for mortgages and other loans they could not afford because those loans could be bundled and sold in the market as collateralized debt obligations (CDOs). The investment banks were thrilled to have those new CDOs to sell, their clients liked the absurdly high returns being paid—even if they really had no clear idea what they were buying—and the “swap” sellers figured they were taking no risk at all, since the economy seemed to have entered a phase in which it had only one direction: up.
Of course, this was ridiculous on the face of it.

…

However, some years before Glass-Steagall was dismantled, Phil’s wife played a key role, as a member of both the Reagan and the Bush I administrations, in shaping the rapid changes in the financial markets brought about by internationalization, computer-driven trading, and the introduction of a whole new discipline of “risk management,” whereby Wall Street wizards deployed complex mathematical models to create a vast array of new financial products, such as the now infamous credit default swaps and collateralized debt obligations.
As was seen throughout the Reagan and later the Bush I and Bush II administrations, the Republicans had realized they could impose de facto deregulation of Big Business by appointing to influential federal commissions and agencies “watchdogs” who were sympathetic to the corporations they were supposed to be monitoring. Of course, this end run around congressional authority was probably not as satisfying or foolproof as wiping out the regulation altogether, yet it proved quite effective in pleasing CEOs, who had spent the 1970s complaining about red tape and overzealous government investigators.

…

Odd then, that when the deregulation of the Clinton years lessened the pressure on the banks to lend to poor people, Republicans after the banking meltdown of 2008 would attempt to blame the subprime mortgage mess on Democratic do-gooders forcing lenders to help out the underclass. In reality, the number of subprime mortgages previously had been steady and grew dramatically only after deregulation. The surge was not a consequence of increased pressure on the banks to make such loans; on the contrary, it was the desire to sell collateralized debt obligations, given “legal certainty” by deregulation that made shaky mortgages newly attractive to the banks.
Why? Because whereas commercial banks previously had held mortgage-based debt obligations, now they were off-loading the long-term responsibility to others to either collect or foreclose on them. While some poor people certainly were eager to accept loans they would have trouble paying back, it was not their happiness the bank was worried about, but what would turn out to be a gushing profit well: the packaging of debt obligations as securities.

With regulation all but suspended, competition to innovate, experiment, and return to the collusions of the 1920s became intense. And before the wax attaching their wings melted Icarus-like in 2007-2008, most of the top fifteen to twenty institutions had bet their fortunes on a host of new financial vehicles and instruments—structured investment vehicles (SIVs), special purpose acquisition companies (SPACs), mortgage securitization, collateralized debt obligations (CDOs), credit default swaps (CDSs), and the like.
Although bountiful in their own right, fees for mergers and acquisitions soon paled alongside the larger benefits of bull markets, assets bubbles, and the uber-profitability of exotic financial instruments. Back in the late 1980s, Goldman Sachs estimated that a major portion of that decade’s stock market upsurge had come from anticipation of takeover bids or buyouts, and other analysts would make the same point about the later M&A floodtides in 2000 and 2006 (see p. 77).

…

Then, to assess real-world vulnerability, the BIS set what they called net risk at $14.5 trillion, and put a plausible gross credit exposure at $3.256 trillion.14
Abstract as these trillion-dollar references may seem to laypeople, global fears of a second wave of exotic financial implosions took shape during 2008. In 2007, mortgage-backed securities and mortgage-linked packages of collateralized debt obligations (CDOs), contaminated by subprime mortgage ingredients, had been the top sources of heartburn. By autumn 2008, financial institutions had already written off some $700 billion of these products. In the meantime, credit default swaps (CDSs), as well as the so-called Synthetic CDOS in which credit swaps also figured, had become the new front burner of crisis management. Commentators were identifying them as the next set of financial dominoes positioned for a costly tumble.

…

This contract extraordinaire permitted borrowers to themselves decide how much to pay, the length of the loan, and when they chose to convert from a fixed rate to a variable rate or back again.18 Who, you might wonder, could offer such a mortgage?
In fact, there was a powerful new reason why banks and other lenders were offering such wide-ranging come-ons to get people to sign up for loans they probably couldn’t afford. That was the heavy demand from securitization shops and bank departments for new carloads of mortgage loans to repackage into mortgage-backed securities or collateralized debt obligations. With the help of misleading or even rigged ratings, these would then be sold for a fat fee to a pension fund in Baton Rouge or a savings bank in Bavaria. The fees were paid up front. It didn’t matter too much what quality of meat was being stuffed into the securitized sausages. In fact, it was often subprime. Financial writer Michael Lewis noted that “In 2000, there had been $130 billion in subprime mortgage lending, with $55 billion being repackaged as mortgage bonds.

That means that their debt gives a wonderfully high yield; and at a time when the yields of everything else are disappointingly low, that makes them the answer to capital’s whispered prayer.
Somebody had long since worked out a way of making collateralized debt obligations out of mortgages, the same way that they had out of corporate debt and bonds and suchlike. Remember, a collateralized debt obligation is a pool of debt being paid back by a group of borrowers, which is added together and then sold on a set of bonds paying a range of different interest rates. Collateralized debt obligations, which had begun with corporate forms of debt, now moved into the area of mortgage holders paying off their mortgages. As always, there would be two streams of revenue, one from the fees to set up the deal and another from the repayments themselves.

…

Morgan had found a way to shift risk off its books, while simultaneously generating income from that risk and freeing up capital to lend elsewhere. It was magic. The only thing wrong with it was the name, BISTRO—standing for Broad Index Secured Trust Offering but making the new rocket-science financial instrument sound like a place you went to for a plate of steak frites. The market came to prefer a different term: “synthetic collateralized debt obligations.”
Just to keep track of where we have got to with these new financial instruments, let’s translate it back into personal finance terms. Remember your arrangement to lend money to the Smiths for their loft—the one you got your other neighbors, the Joneses, to insure. That was a straightforward swap of risk. The deal went fine, and you fell to thinking about how it might be improved if another neighbor were to approach you.

…

This is a gigantic insurance company, worth $200 billion at its peak and definitely “too big to fail.” It was AIG which was, in effect, the Joneses. It was the company which underwrote all the insurance: it was the single biggest player in the CDS market. Entertainingly for fans of financial acronyms, AIG was done in by CDSs on CDOs. That’s to say, it took part in credit default swaps on collateralized debt obligations, the pools of subprime mortgages whose dramatic collapse in value in 2008 was the proximate cause of the financial crisis. When the investment bank Lehman Brothers imploded in September 2008, done in by its exposure to bad assets, there was a generalized panicked scramble to see who else was carrying similar risk. When it turned out that AIG was—and worse, that it was valuing those assets at much higher prices than Lehman Brothers had—investors freaked out and the company’s credit rating collapsed.

This is informative on how responsible use of market technology might have avoided the crisis and can help avoid an
even more dreadful sequel in the future. Technology errors
of omission and commission have contributed to our
present woes. Stock markets are almost perfectly transparent, with full information available to all, and the best electronic clearing and settlement in history. These technologies
were omitted in building the skyscraper of cards (“house of
cards” seems too mild) out of collateralized debt obligations
(CDOs), credit default swaps (CDSs), synthetic collateralized
debt obligations (SCDOs), and the rest.
The Hall of Shame for those guilty of incompetent
engineering features collapsing bridges, flaming dirigibles, exploding spacecraft, and melting reactors. We can add
a new wing for overly complex derivatives, modeled in
exquisite detail by myopic nerds with Ph.D.’s who got lost
in the ever more complex simulations but ignored the basic
principles, and their lavishly paid bosses who ignored the
warnings from the best of them so they could be even more
lavishly paid.

Morgan’s proprietary name for the idea of creating CDOs out of credit derivatives. It was first launched in 1997 and was the forerunner of the synthetic CDO structure that later became widespread.
Collateralized Debt Obligations (CDOs): A form of asset-backed security. They are typically created by bundling together a portfolio of fixed-income debt (such as bonds) and using those assets to back the issuance of notes. Such notes usually carry varying levels of risk. Cash CDOs are created from tangible bonds, bonds, or other debt; synthetic CDOs sare created from credit derivatives.
Collateralized Debt Obligations of Asset Backed Securities (CDO of ABS): CDOs built out of asset-backed securities, which are usually (but not always) types of mortgage-backed bonds.
Collateralized Loan Obligations: CDOs built out of loans, which are usually “leveraged loans” (those extended to companies whose debt is rated noninvestment grade).

…

Did they fail to see the flaws, or did they fail to care?
This book explores the answer to the central question of how the catastrophe happened by beginning with the tale of a small group of bankers formerly linked to J.P. Morgan, the iconic, century-old pillar of banking. In the 1990s, they developed an innovative set of products with names such as “credit default swaps” and “synthetic collateralized debt obligations” (of which more later) that fall under the rubric of credit derivatives. The Morgan team’s concepts were diffused and mutated all around the global economy and collided with separate innovations in mortgage finance. These then played a critical role in both the great credit bubble and its subsequent terrible bursting. The J.P. Morgan team were not the true inventors of credit derivatives.

…

However, one more obstacle still stood in the way of the team unleashing its revolution, and it was a daunting one. They still had to find a way to process a high volume of deals rapidly; to industrialize the CDS trade, transforming it from a cottage industry into a mass-production business.
The crucial, last piece of the puzzle that fell into place went by the strange name “BISTRO” (although bankers would later give the idea an even stranger tag, “synthetic collateralized debt obligations”). This brainchild emerged from months of heated debate and experimentation. By the mid-1990s, Hancock’s group had two views of how to make credit derivatives work large-scale. In London, Bill Winters was inclined to try to create what bankers call a “liquid market” in credit derivatives. That would entail finding a way to make credit derivatives as easy for clients and investors to buy and sell as stocks, and might even require setting up an exchange.

For example, if a person gets a mortgage,
the collateral would be the house. In margin stock trading, the securities in the account act as collateral against the margin loan.
44 The Investopedia Guide to Wall Speak
Related Terms:
• Asset
• Margin
• Regulation T
• Asset-Backed Security
• Margin Call
Collateralized Debt Obligation (CDO)
What Does Collateralized Debt Obligation (CDO) Mean?
An investment-grade security that is backed by a pool of bonds,
loans, and other assets. CDOs represent various debt obligations but
are often nonmortgage loans or bonds.
Investopedia explains Collateralized Debt Obligation (CDO)
Similar in structure to a collateralized mortgage obligation (CMO)
or a collateralized bond obligation (CBO), CDOs are unique in that
they represent different types of debt and credit risk. In the case of
CDOs, these different types of debt often are referred to as tranches
or slices.

This country (if not the world) is guilty of some major financial mistakes. This isn’t just Main Street we’re talking about; Wall Street has
made plenty of mistakes too. Therefore, we believe that the need for
financial education among young people applies not only to those
who might fall prey to adjustable-rate mortgages or credit card debt
xii The Investopedia Guide to Wall Speak
but also to the Wall Street set who staked their futures on collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and
other creations of financial engineering that have emerged over the
last few decades.
Similarly, there has been no shortage of talk about the world’s “credit
binge,” but this discussion rarely addresses what we view as the root
cause: lack of education. Just look at the credit crisis: A general lack of
knowledge extended all the way down the line, from the homeowner
who didn’t read the details of his or her mortgage document, to the
investment bank that sold it, to the institutional investor who bought
it, to the credit rating agency that rated it, and to the politician who
failed to regulate it.

When John Gutfreund became CEO of Salomon in 1978, all commercial banks together held $1.2 trillion of assets, equivalent to 53 percent of U.S. GDP. By the end of 2007, the commercial banking sector had grown to $11.8 trillion in assets, or 84 percent of U.S. GDP. But that was only a small part of the story. Securities broker-dealers (investment banks), including Salomon, grew from $33 billion in assets, or 1.4 percent of GDP, to $3.1 trillion in assets, or 22 percent of GDP. Asset-backed securities such as collateralized debt obligations (CDOs), which hardly existed in 1978, accounted for another $4.5 trillion in assets in 2007, or 32 percent of GDP.* All told, the debt held by the financial sector grew from $2.9 trillion, or 125 percent of GDP, in 1978 to over $36 trillion, or 259 percent of GDP, in 2007.13
Some of this growth was due to an increase in borrowing by the nonfinancial sector—the “real economy.” However, the expansion of the financial sector vastly outpaced growth in households and nonfinancial companies.

…

Reverse convertibles, for example, are structured notes where the investor gets either a fixed interest rate or a share of stock, depending not only on the final stock price but on the path it takes getting there; because of their complexity, few investors are able to value them accurately, making them prey to unscrupulous brokers and banks.49 (“I was told there was no risk with these,” said one retiree who lost over $90,000 on reverse convertibles.)50
The ideology of innovation had its skeptics. Warren Buffett famously labeled derivatives “financial weapons of mass destruction” in the Berkshire Hathaway 2002 annual report.51 In his 2001 book Fooled by Randomness, Nassim Taleb argued that modern financial technology underestimated the likelihood of extreme events, with potentially catastrophic implications.52 Janet Tavakoli’s 2003 book, Collateralized Debt Obligations and Structured Finance, discussed the potential problems involved in securitization, including the risk of fraud.53 And decades before, Hyman Minsky had pointed out the role of innovation in enabling financiers to increase their profits at the risk of destabilizing the economy.54 They could all be ignored as long as market conditions remained benign. But the Merton-Greenspan “risk unbundling” story was proven horribly wrong by the financial crisis that began in 2007—caused in part by innovative products that made it possible for financial institutions and investors to take on massive amounts of risk hidden inside AAA-rated securities that later plummeted in value.

Very short-term loans, allowing firms to conduct their daily business, backed by mortgages or other assets. Part of the “plumbing” of Wall Street.
ABS: Asset-backed securities. Bonds comprising thousands of loans—which could include credit card debt, student loans, auto loans, and mortgages—bundled together into a security.
AIG: American International Group.
ARM: Adjustable-rate mortgage.
CDOs: Collateralized debt obligations. Securities that comprise the debt of different companies or tranches of asset-backed securities.
CDOs Squared: Collateralized debt obligations squared. Securities backed by tranches of other CDOs.
CFTC: Commodities Futures Trading Commission. Government agency that regulates the futures industry.
CSE: Consolidated supervised entities. An effort by the Securities and Exchange Commission in 2004 to create a voluntary supervisory regime to regulate the big investment bank holding companies.

…

For years, Wall Street had been churning out these securities. Many of them had triple-A ratings, meaning they were considered almost as safe as Treasury bonds. No firm had done more of these deals than Merrill Lynch.
Calling in a favor from a friend in the finance department, Breit got ahold of a spreadsheet that listed the underlying collateral for one security on Merrill’s books, something called a synthetic collateralized debt obligation squared, or sythentic CDO squared. As soon as he looked at it, Breit realized that the collateral—bits and pieces of mortgage loans that had been made by subprime companies—was awful. Many of the mortgages either had already defaulted or would soon default, which meant the security itself was going to tumble in value. The triple-A rating was in jeopardy. Merrill was likely to lose tens of millions of dollars on just this one synthetic CDO squared.

…

Years later, by which time he was running FP—and not long before the first glimmers of the financial crisis could be seen on the horizon—Cassano spoke at an investment conference in which he boasted about being involved in that original BISTRO deal. “It was a watershed event in 1998 when J.P. Morgan came to us, who were somebody we worked with a great deal, and asked us to participate,” he said. “These trades were the precursors to what’s become the CDO market today.”
CDO stood for collateralized debt obligation, which is what that BISTRO-type structure was eventually called. By 2007, when Cassano made those remarks, Wall Street churned them out as if they were coming off an assembly line. There was, however, one giant difference between the early BISTRO deals and the CDOs of 2007. At the heart of the early BISTRO deals was corporate debt. But at the heart of the CDO market of 2007 was something far more dangerous: mortgages.
6
The Wizard of Fed
Inevitably, the nation’s first subprime boom ended badly.

It is not the dash for risk that lands the world’s financial system in trouble; it is the hunt for safe returns.
These new instruments are attended by risks that are different from those of the old ones they are substituting for, however. Putting money into AAA-rated Treasuries is a transparent bet on the full faith and credit of the US government. Putting money into highly rated “collateralized-debt obligations” (CDOs), which bundle up the lower tranches of existing securitizations, was an opaque bet that America would not suffer a national housing-market meltdown. Similarly, putting your money into a bank account is a decision that is informed by an explicit system of deposit insurance: you will get your money back because the government guarantees it. For many, investing in a money-market fund is also a bet on a promise, but this time by a private actor not to “break the buck”—in other words, to give a dollar back for each dollar invested.

…

Raising a multibillion-dollar fund is going to take a long time, but Lo is hopeful that a smaller proof-of-­concept fund, devoted to drugs for “orphan” diseases that affect fewer than two hundred thousand individuals, will come to fruition more quickly.
Some people will be holding their heads in their hands at the thought of using securitization to take on cancer. Isn’t this the same sort of financial wizardry that created those infamous collateralized-­debt obligations that were stuffed with subprime loans during the mortgage boom? In an echo of these instruments, Lo and his colleagues have christened the proposed drug megafund “research-backed obligations.” Why invest hope in a technology that caused so much damage? For that matter, why aim for such a big amount? Couldn’t Lo make life easier for himself and aim for a smaller, simpler fund?
The answer to that question tells you something about why financial engineering exists at all.

…

In fact, as a judgment about the likelihood that these instruments would default, the AAA standard performed better than you might think. One surprising statistic to come out of the subprime crisis is from a little-reported analysis by Sun Young Park, now an assistant professor at the Korea Advanced Institute of Science and Technology. She analyzed the actual performance of subprime tranches of mortgage-backed securities—not collateralized-debt obligations, but the preceding step in the securitization chain—­issued in the United States between 2004 and 2007 and looked at how many losses had actually been sustained. A total of $1.1 trillion in AAA-rated subprime MBS tranches were issued in that period, and Park identified a loss amount on these securities of $2.6 billion by August 2013. That amounts to a loss percentage of only 0.24 percent.

There is no agreed-upon definition of the shadow banking system, but the institutions involved on the eve of the crisis included nonbank loan originators; the two government-sponsored housing agencies, Fannie Mae and Freddie Mac; other so-called private-label securitizers; the giant investment banks (who were often securitizers, too); the aforementioned SIVs; a variety of finance companies (some of which specialized in housing finance); hedge funds, private equity funds, and other asset managers; and thousands of mutual, pension, and other sorts of investment funds.
The markets involved included those for mortgage-backed securities (MBS), other asset-backed securities (ABS), commercial paper (CP), repurchase agreements (“repos”), and a bewildering variety of derivatives, including the notorious collateralized debt obligations (CDOs) and the ill-fated credit default swaps (CDS). (Sorry about the alphabet soup—explanations to come.)
By most estimates, the shadow banking system was far larger than the conventional banking system. Imagine leaving all that financial activity almost totally unregulated—like a bunch of wild animals running around without zookeepers. Well, actually, you don’t have to imagine it.

…

The most junior tranche, which came to be called the “toxic waste,” would absorb, say, the first 8 percent of losses in the pool ($32 million)—no matter which mortgages defaulted. The middle, or “mezzanine,” tranche might absorb the next 2 percent ($8 million), leaving owners of the top-rated, or “senior,” tranche vulnerable only to losses above 10 percent ($40 million)—an event that seemed so unlikely as to be nearly impossible. Call the resulting three-tranche bundle of securities a CDO (collateralized debt obligation). This example is unrealistically simple, by the way. Typical CDOs had seven or eight tranches; some had more.
Now, think about what happens to the various tranches of the CDO as losses on mortgages rise from negligible to monumental. As long as loan losses remain below 8 percent, only the owners of the toxic waste take any hit. Owners of the two higher tranches continue to receive full payment.

It goes without saying that this attracted players to the market like flies to a lamp.
Increasingly sophisticated varieties of securitization also began to evolve. When large bunches of mortgages have been resold as securities, other investors can buy a few hundred such securities of different origins, for example medium-risk ones, and repackage them once more into a new kind of security, a "collateralized-debt obligation," or CDO. That will also be split into tranches depending on the level of risk that buyers are willing to take. The original idea of CDOs was to spread risk by including a wide variety of assets, but in 2003, Wall Street firms started to create CDOs backed exclusively by mortgages. Similar to an ordinary mortgage-backed security, the buyer who picks the riskiest tranches gets paid the most but also has to suffer the first loss if the CDO investments fail.

…

It is better for the bank to have someone living in the house, who may be able to pay back the loan in the longer term, than to be forced to take over the house and try to sell it just when prices are lowest. But the securitization of mortgages had led to an unexpected consequence: The original lender no longer owned the loan, because it had been repackaged and sold and then chopped up and sold as part of a collateralized-debt obligation. Households in default no longer had an individual lender to negotiate with, which made more and more of them just abandon their homes and either buy something cheaper or start renting.
On July 24, 2007, the mortgage giant Countrywide held one of its regular conference calls with investors and analysts from Bear Stearns, Merrill Lynch, Morgan Stanley, and the rest of the Wall Street elite.

A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data available
ISBN 978 1 78032 646 7
Contents
ABBREVIATIONS
PREFACE TO THE NEW EDITION
ACKNOWLEDGEMENTS
1 Introduction
2 Laboratories of the future
3 The Global Plan
4 The Global Minotaur
5 The beast’s handmaidens
6 Crash
7 The handmaidens strike back
8 The Minotaur’s global legacy: the dimming sun, the wounded tigers, a flighty Europa and an anxious dragon
9 A world without the Minotaur?
POSTCRIPT TO THE NEW EDITION
NOTES
RECOMMENDED READING
SELECT BIBLIOGRAPHY
INDEX
Abbreviations
AC alternating current
ACE aeronautic–computer–electronics complex
AIG American Insurance Group
ATM automated telling machine
CDO collateralized debt obligation
CDS credit default swap
CEO chief executive officer
DC direct current
ECB European Central Bank
ECSC European Coal and Steel Community
EFSF European Financial Stability Facility
EIB European Investment Bank
EMH Efficient Market Hypothesis
ERAB Economic Recovery Advisory Board
EU European Union
FDIC Federal Deposit Insurance Corporation
GDP gross domestic product
GM General Motors
GSRM global surplus recycling mechanism
IBRD International Bank for Reconstruction and Development
ICU International Currency Union
IMF International Monetary Fund
LTCM Long-Term Capital Management (hedge fund)
MIE military–industrial establishment
NAFTA North American Free Trade Agreement
NATO North Atlantic Treaty Organization
OECD Organisation for Economic Co-operation and Development
OEEC Organisation for European Economic Co-operation
OMT outright monetary operations
OPEC Organization of the Petroleum Exporting Countries
RBCT Real Business Cycle Theory
RBS Royal Bank of Scotland
REH Rational Expectations Hypothesis
RMB renminbi – Chinese currency
SME small and medium-sized enterprise
SPV Special Purpose Vehicle
TARP Troubled Asset Relief Program
For Danae Stratou, my global partner
Preface to the new edition
This book originally aimed at pressing a useful metaphor into the service of elucidating a troubled world; a world that could no longer be understood properly by means of the paradigms that dominated our thinking before the Crash of 2008.

…

Buyers cannot taste the ‘produce’, squeeze it to test for ripeness, or smell its aroma. They rely on external, institutional information and on well-defined rules that are designed and policed by dispassionate, incorruptible authorities. This was the role, supposedly, of the credit rating agencies and of the state’s regulatory bodies. Undoubtedly, both types of institution were found not just wanting but culpable.
When, for instance, a collateralized debt obligation (CDO) – a paper asset combining a multitude of slices of many different types of debt4 – carried a triple-A rating and offered a return 1 per cent above that of US Treasury Bills,5 the significance was twofold: the buyer could feel confident that the purchase was not a dud and, if the buyer was a bank, it could treat that piece of paper as indistinguishable from (and not an iota riskier than) the real money with which it had been bought.

…

Meanwhile, in the two former US protégés, Germany and Japan (the two countries that were financing the Anglo-Celtic deficits through their industrial production, which the Anglo-Celtic countries were, in turn, absorbing), not only did house prices not increase but they actually dropped, at least in the case of Germany.
The graphic correlation shown in the figure between the housing bubble and consumption-driven growth was reinforced by a famous instrument: securitized derivatives or collateralized debt obligations (those CDOs again). How did they link housing debt with consumption-driven growth? To answer this question, it is helpful to begin with a self-evident truth: the banks’ main principle has traditionally been never to lend to anyone unless they do not need the money. But this principle clashed with the urge to lend to those poor enough to be willing to pay higher interest rates than those who had other alternatives (i.e. the rich).

Back home, where it was impossible to make money in bank accounts with a 2 percent rate, high-yield bonds were plainly the answer, and they became as fashionable as stock in dot-com companies had once been. But Wall Street had outsmarted everyone, and instead of the old-fashioned regular reliable bonds, investors now stampeded for residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), and structured investment vehicles (SIVs), paying around 5 to 8 percent.
Securitization. What a stroke of pure genius. Turning those mortgage debts into tangible entities. Hardly anyone noticed the minor flaws that would, in time, bankrupt half the world.
The year 2003 turned into 2004, and still the flame of my ambitions burned as strongly as ever.

…

And as the years went by, Dick Fuld had tightened his circle, shutting out more and more key people from the downstairs floors where the daily action seethed, where the trading battles ebbed and flowed, where more critical information flew around than anywhere else in the city. That was the place from which he had, to all intents and purposes, removed himself. In the process, he had become separated from the most modern technology and the ultramodern trading of credit derivatives—CDO (collateralized debt obligations), RMBS (residential mortgage-backed securities), CLO (collateralized loan obligations), CDS (credit default swaps), and CMBS (commercial mortgage-backed securities).
Stories about long-departed commanders were legion. There were mind-blowing tales of the Fuld temper, secondhand accounts of his rages, threats, and vengeance. It was like hearing the life story of some caged lion. Tell the truth, I ended up feeling pretty darn glad I wasn’t meeting him.

…

In that bright fall of 2004, we were in the presence of gods, the new Masters of the Universe, a breed of financial daredevils who conjured Lehman’s billion-dollar profits out of one of the most complex markets ever to show its head above Wall Street’s ramparts.
This was the Age of the Derivative—the Wall Street neutron that provided atomic power to one of the most reckless housing booms in all of history. Derivative number one was the fabled CDO, the collateralized debt obligation. This new “technology” was created and perfected in Wall Street’s investment banks, including Lehman but especially at Merrill Lynch.*
Like most sensational ideas, this one was simple, and in a sense solidly based. The process began in the offices of large U.S. mortgage brokers, particularly in California, Florida, and Nevada, where the prospect of a fast buck has never antagonized the natives.

Among them, the three banks held $2.5 billion of junk bonds by the end of 1984—which was equal to 35 percent of the amount held by all mutual funds.22 (William Seidman later wrote that of the more than 900 convictions initiated by RTC enforcement actions, those of the chairmen of Centrust, Columbia, and Charles Keating were “key.”23)
Later in the decade, Seidman’s investigators discovered that Michael Milken had “rigged the market by operating a sort of daisy chain among the S&Ls to trade the bonds back and forth across his famous X-shaped trading desk at his headquarters in Beverly Hills. By manipulating the market, he maintained the facade that the bonds were trading at genuine market prices. . . . When he [Milken] was brought down, and his trading operation with him, so were the S&Ls that depended on the value of his bonds to stay afloat.”24 Of note: the in-house pricing of derivatives, such as collateralized debt obligations (CDOs), was essential to the current financial collapse.
Between 1983 and 1984, Lincoln’s assets more than doubled, from $1.1 billion to $2.24 billion.25 From the time Keating took control of Lincoln in February 1984 through the end of the year, he “had switched virtually all of its activities to real estate development and speculative investments.”26
21 Ibid., p. 346. Wigmore includes one more “old hand” from “the merger wave of the late 1960s”: Meshulam Riklis and his Rabid American Corporation.
22 Ibid., p. 286.
23 Seidman, Full Faith and Credit, p. 226.
24Ibid., p. 236.

…

The date of Greenspan’s first broadside is interesting—one day after his ode to adjustable-rate mortgages. (This will be discussed in the next chapter.) An obvious interpretation is a Greenspan attempt to take business from the GSEs and move it to the banks. This might have been true earlier, but by 2004, the largest banks and brokerage houses needed the higher mortgage volume that flowed through the agencies to create more complicated and profitable securities, such as collateralized debt obligations (see “The Washington-New York Symbiosis” which follows).21
Testifying before the Senate Banking Committee, Alan Greenspan took up the cudgels and warned that “GSEs need to be limited in the issuance of GSE debt and in the purchase of assets, both mortgages and non-mortgages, that they hold.”22 Later the same year, the Office of Federal Housing Enterprise Oversight cited “numerous examples of accounting irregularities and managerial conflicts that OFHEO examiners contended were used to doctor Fannie’s earnings and inflate executive compensation.”23
Fannie Mae’s chairman, Franklin Raines, who had been Bill Clinton’s budget director, declared his innocence even as he was escorted out the door.

…

The GrammLeach-Bliley Act (its formal name: The Financial Services Modernization Act) became law on November 12, 1999.57 Rubin had left his treasury post to join Citicorp.58 Larry Summers, treasury secretary when the act passed, claimed: “This historic legislation will better enable American companies to compete in the new economy.”59
Greenspan, Rubin, and Summers played a major role ensuring that the wildest derivatives remained unregulated. To thrive, the mortgage machine needed such developments as collateralized debt obligations (CDO) and credit default swaps (CDS). The trio led the offense against regulation of over-the-counter derivatives. Deputy Treasury Secretary Larry Summers told Congress that any oversight would cast “a shadow of regulatory uncertainty over an otherwise thriving market.”60 Without the contributions of Greenspan, Rubin, and Summers, the credit bubble might have been a muted affair. Timothy Geithner, secretary of the treasury in 2009, served under both Robert Rubin and Larry Summers as undersecretary of the treasury for international affairs.

Banks like Lehman Brothers were eager to buy as many mortgages as they could get their hands on because the game of hot potato usually didn’'t stop with them. Wall Street used the mortgages as the raw material for a slew of “"securitized”" investments sold to investors. Indeed, one of the things the United States excelled at was slicing up mortgages and other loans into complex investments with esoteric names—--such as mortgage-backed securities, collateralized-debt obligations, asset-backed commercial paper, and auction-rate securities—--and selling them to Japanese pension plans, Swiss banks, British hedge funds, U.S. insurance companies, and others around the globe.
Though these instruments usually didn’'t trade on public exchanges, and this booming world was foreign to most investors and home owners, the securitization process was less mysterious than it seemed.

…

He developed a new method to use “"statistical arbitrage”" to trade stocks, though he couldn’'t make much money with it. A stint at Tricadia Capital, a hedge fund founded by Michaelcheck’'s Mariner Investment Group, Inc., gave Pellegrini an education in the world of securitized debt and credit-default swaps (CDS), which the firm was heavily involved in.
But Pellegrini didn’'t make many friends at Tricadia when he suggested that the firm find ways to short collateralized-debt obligations, even as others at the firm were buying and creating versions of these debts. After a derivative-focused company that Pellegrini hoped to set up for Tricadia failed to get off the ground, he began searching for a job once again. It was that development that led him to the interview that Paulson set up for him with two of Paulson’'s executives, Andrew Hoine and Michael Waldorf.
The meeting started with Hoine and Waldorf asking Pellegrini for his views on various European industries.

…

Their actuaries produced sophisticated models that showed the chances of a housing meltdown were minimal.
With a feat of financial and legal engineering, the subprime mortgage market had effectively grown by leaps and bounds, a fact that would come back to haunt both Wall Street and global economies. In the months ahead, the bankers created similar insurance contracts for securities backed by loans for commercial buildings and collateralized debt obligations. They’'d even create a CDS insurance contract for an index that tracked a group of subprime mortgages, called the ABX, a sort of a Dow Jones Industrial Average for risky home mortgages.
Lippmann and the other bankers had no idea of the impact their change would have on Wall Street, the banks, and the entire global economy. They just wanted another product to sell to their clients.

An unflattering portrayal of Fuld has him holed up in his office on the 31st floor of Lehman’s headquarters with little knowledge of what was going on in the rest of the building.9 Indeed, in a tongue-in-cheek op-ed piece in the New York Times, Calvin Trillin argued that Wall Street’s problem was that it had undergone a revolutionary change in the quality of personnel over generations.10 In Trillin’s time in college, only those in the bottom third of their university class used to go on to Wall Street careers, which were boring and only moderately remunerative. But even while the dullards ascended to the top positions at the banks, Wall Street became a more exciting and challenging place, paying people beyond their wildest dreams. It started attracting and recruiting the smartest students in class, people who thought they could price CDO squared and CDO cubed (particularly egregious forms of securitization involving collateralized debt obligations) and manage their risks. As Trillin writes: “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.”11
The suggestion that bosses, recruited in a staid and regulated era, were of lower caliber than the employees they had recruited from the top of the class in a deregulated and high-paying era is not completely without foundation.

…

The right approach would be to reduce the various distortions to the pricing of risk that stem from actual and potential government intervention, as well as from herd behavior. We should not worry so much about rugged individualism as about undifferentiated groupthink, for that is the primary source of systemic problems.
A competitive system is also likely to produce the financial innovation necessary to broaden access and spread risk. Financial innovation nowadays seems to be synonymous with credit-default swaps and collateralized debt obligations, derivative securities that few outside Wall Street now think should have been invented. But innovation also gave us the money-market account, the credit card, interest-rate swaps, indexed funds, and exchange-traded funds, all of which have proved very useful. So, as with many things, financial innovations span the range from the good to the positively dangerous. Some have proposed a total ban on offering a financial product unless it has been vetted, much as the Food and Drug Administration vets new drugs.

These include:
• Developing Country Debt Crisis (1983)
• US Savings and Loan Crisis (1980s)
• Resolution Trust Company, which created REITS (Real Estate Investment Trusts) (late 1980s)
• The 1988 Basel Capital Accord (1988)
• The beginning of derivatives (early 1990s)
• Proliferation of derivatives and Special Purpose Entities (SPEs) (1990s)
• Asian Financial Crisis (1997–1998)
• Collapse of Long-Term Capital Management (LTCM) (1998)
• The repeal of Glass-Steagall (1999) and the adoption of Gramm-Leach-Bliley Financial Modernization Act (GLBA) (1998)
• The failure of dot-coms (2000)
Causes of the Global Financial Crisis after SOX and Prior to September 18, 2008
It is also important to understand the events and economic climate after the July 31, 2002, passage of SOX and prior to September 18, 2008. These events include:
• The increasing complexity of derivative products, including CDSs (Credit Default Swaps) and CDOs (Collateralized Debt Obligations)4
• The ascendancy of rating agencies
• Alt-A subprime lending
• Basel II (2005–2006)
• The subprime housing crisis in the United States, including the rise of “NINJA” (no income, no jobs, no assets) financing
• The rise of hedge funds
• The oil crisis (2008)
• The collapse of Bear Stearns, Fannie Mae, Freddie Mac, and Lehman Brothers (2008)
Understanding the causes of the global financial crisis will go hand in hand with regulatory reform and increasing targeted global compliance and ethics programs.5
Why SOX Failed
SOX was supposed to remedy the financial improprieties and excesses that existed prior to July 31, 2002.

…

These events include:
• The increasing complexity of derivative products, including CDSs (Credit Default Swaps) and CDOs (Collateralized Debt Obligations)4
• The ascendancy of rating agencies
• Alt-A subprime lending
• Basel II (2005–2006)
• The subprime housing crisis in the United States, including the rise of “NINJA” (no income, no jobs, no assets) financing
• The rise of hedge funds
• The oil crisis (2008)
• The collapse of Bear Stearns, Fannie Mae, Freddie Mac, and Lehman Brothers (2008)
Understanding the causes of the global financial crisis will go hand in hand with regulatory reform and increasing targeted global compliance and ethics programs.5
Why SOX Failed
SOX was supposed to remedy the financial improprieties and excesses that existed prior to July 31, 2002. The debacles of WorldCom, Enron, Adelphia, and Tyco were only the last in a long series of financial abuses. Further, after SOX, despite the subprime mortgage crisis in the United States, rating services failed to calculate the risk of credit default swaps (CDSs), collateralized debt obligations (CDOs), and other financial abuses. Until September 18, 2008, there was no general sense that SOX had not alleviated the possibility of a global financial meltdown, or at least a US financial meltdown. No one seemed to question SOX’s ability to create greater transparency and integrity in the US financial market. However, SOX ultimately failed to deliver the kind of protection its framers anticipated.

…

If neuroeconomics provides such incontrovertible evidence relating to the making of flawed decisions, why are so many investors still “neuroskeptics”? Why is it that so very few investment companies have neuroeconomists or cognitive psychologists on their board, their trading floor, or their investment committee? Probably because neuroeconomics does not help to make better decisions; it only helps to avoid bad ones, which is much less noticeable. It pays more to sell a collateralized debt obligation to a client than to warn him or her about the hidden risks, many of which would be apparent if one ever paid attention to a bias as obvious as overconfidence. But the fundamental reason for which we still do not pay enough attention to the lessons of neuroeconomics may be simpler yet. On repeated occasions, I have asked renowned neuroeconomists why so very few investors pay for their services.

There was no historical precedent for such low-quality mortgages. It is easy to see how the BBB tranche of a bond formed from these low-quality mortgages would be extremely vulnerable to a complete loss.
The story, however, does not end there. Not surprisingly, the BBB tranches were difficult to sell. Wall Street alchemists came up with a solution that magically transformed the BBB tranches into AAA. They created a new securitization called a collateralized debt obligation (CDO) that consisted entirely of the BBB tranches of many mortgage bonds.2 The CDOs also employed a tranche structure. Typically, the upper 80 percent of a CDO, consisting of 100 percent BBB tranches, was rated AAA.
Although the CDO tranche structure was similar to that employed by subprime mortgage bonds consisting of individual mortgages, there was an important difference. In a properly diversified pool of mortgages, there was at least some reason to assume there would be limited correlation in default risk among individual mortgages.

…

If conditions for the strategy are favorable, the risk of such leverage may not be readily evident in the track record other than through high returns.
Another problem with leverage relates to the kind of leverage instrument used. A mismatch occurs when funds use short-duration leverage instruments to enhance the returns of a longer-duration asset, such as using short-term commercial paper to fund mortgage-backed collateralized debt obligations (CDOs). Here there is risk of not being able to roll over funding.
Although excessive or unwarranted use of leverage is one of the main factors responsible for episodes of large losses by hedge funds, including those severe enough to result in the fund’s demise (blowups), it is important to note that leverage can also be used as a tool to reduce risk through hedging, as in the case of the classic Jones model hedge fund detailed in Chapter 10.

The other fund, the High-Grade Structured Credit Strategies Enhanced Leverage Fund, launched in 2006 and, assuming more risk with a leverage ratio of twelve to one, had no investor capital left.
The funds were designed for highly complex operations in the mortgage markets. Though the methods were complicated, the underlying profit plan was simple: Borrow a large amount of money to make big bets on the subprime mortgage-backed securities market.
Cioffi thought collaterized debt obligations (CDOs) backed by subprime mortgages would start to increase in value over the longer term, following their recent decline.2
Bear Stearns was one of the biggest operators in the mortgage business, and with Cioffi’s reputation, it found fund money easy to come by. Some of the world's biggest finance companies, including Citigroup, Barclays, Merrill Lynch, Goldman Sachs, Deutsche Bank, Credit Suisse, and Bank of America, extended as much as $9 billion in credit to these funds.

…

The firm’s treasurer, Bob Upton, said that this window dressing was important for keeping creditors and rating agencies happy.11
Repo Power
The repo system is the primary method that Wall Street firms use for maturity transformation and leverage.12 Among Wall Street firms, Bear Stearns had been one of the most heavily involved in the repo system.
The repo mechanism is a way to borrow and invest. A repo is collateralized lending: one bank gives another a security in exchange for cash. The collateral typically takes a haircut, depending on how risky or liquid the security is. A loan might be 99% of a U.S. Treasury bond’s value, but just 95% of a mortgage security’s value.
Bear Stearns bought mortgage-backed securities or collateralized debt obligations, then repo’d them immediately, effectively leveraging the investments. Suppose the MBS cost Bear $100,000. When the firm gave another bank the security in a repo, Bear received $95,000. Bear effectively bought the MBS with $5,000 of its own cash and $95,000 in borrowed cash, for a leverage ratio of 20. At the end of the repo transaction, Bear (or another repo party) returns the borrowed cash, plus interest at the repo interest rate,13 and the counterparty returns the security.

And all the time new financial life forms are evolving. In 2006, for example, the volume of leveraged buyouts (takeovers of firms financed by borrowing) surged to $753 billion. An explosion of ‘securitization’, whereby individual debts like mortgages are ‘tranched’ then bundled together and repackaged for sale, pushed the total annual issuance of mortgage backed securities, asset-backed securities and collateralized debt obligations above $3 trillion. The volume of derivatives - contracts derived from securities, such as interest rate swaps or credit default swaps (CDS) - has grown even faster, so that by the end of 2007 the notional value of all ‘over-the-counter’ derivatives (excluding those traded on public exchanges) was just under $600 trillion. Before the 1980s, such things were virtually unknown. New institutions, too, have proliferated.

…

The proximate cause of the economic uncertainty of 2008 was financial: to be precise, a spasm in the credit markets caused by mounting defaults on a species of debt known euphemistically as subprime mortgages. So intricate has our global financial system become, that relatively poor families in states from Alabama to Wisconsin had been able to buy or remortgage their homes with often complex loans that (unbeknown to them) were then bundled together with other, similar loans, repackaged as collateralized debt obligations (CDOs) and sold by banks in New York and London to (among others) German regional banks and Norwegian municipal authorities, who thereby became the effective mortgage lenders. These CDOs had been so sliced and diced that it was possible to claim that a tier of the interest payments from the original borrowers was as dependable a stream of income as the interest on a ten-year US Treasury bond, and therefore worthy of a coveted triple-A rating.

…

Instead of putting their own money at risk, they pocketed fat commissions on signature of the original loan contracts and then resold their loans in bulk to Wall Street banks. The banks, in turn, bundled the loans into high-yielding residential mortgage-backed securities (RMBS) and sold them on to investors around the world, all eager for a few hundredths of a percentage point more return on their capital. Repackaged as collateralized debt obligations (CDOs), these subprime securities could be transformed from risky loans to flaky borrowers into triple-A rated investment-grade securities. All that was required was certification from one of the two dominant rating agencies, Moody’s or Standard & Poor’s, that at least the top tier of these securities was unlikely to go into default. The lower ‘mezzanine’ and ‘equity’ tiers were admittedly more risky; then again, they paid higher interest rates.

Later in the 1990s, many fast-growing Asian countries, including Thailand, Indonesia, and South Korea, endured serious financial blowups. In 2007–2008, it was our turn again, and this time the crisis involved the big banks at the center of the financial system.
For years, Greenspan and other economists argued that the development of complicated, little-understood financial products, such as subprime mortgage–backed securities (MBSs), collateralized debt obligations (CDOs), and credit default swaps (CDSs), made the system safer and more efficient. The basic idea was that by putting a market price on risk and distributing it to investors willing and able to bear it, these complex securities greatly reduced the chances of a systemic crisis. But the risk-spreading proved to be illusory, and the prices that these products traded at turned out to be based on the premise that movements in financial markets followed regular patterns, that their overall distribution, if not their daily gyrations, could be foreseen—a fallacy I call the illusion of predictability, the third illusion at the heart of utopian economics.

…

In the past couple decades, he reminded the audience, deregulation and technical progress had subjected banks to increasing competition in their core business of taking in deposits from households and lending them to other individuals and firms. In response, the banks had expanded into new fields, including trading securities and creating new financial products, such as mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). Most of these securities the banks sold to investors, but some of them they held on to for investment purposes, which exposed them to potential losses should the markets concerned suffer a big fall. “While the system now exploits the risk-bearing capacity of the economy better by allocating risks more widely, it also takes on more risks than before,” Rajan said. “Moreover, the linkages between markets, and between markets and institutions, are now more pronounced.

…

THE PRISONER’S DILEMMA AND
RATIONAL IRRATIONALITY
As the problems of pollution and free riding make clear, many types of market failure come down to the fact of human interdependence. What I do affects your welfare; what you do affects mine. The same applies in business. When General Motors cuts its prices or offers interest-free loans, Ford and Chrysler come under pressure to match GM’s deals, even if their finances are already stretched. If Merrill Lynch sets up a hedge fund to invest in collateralized debt obligations or some other newfangled securities, Morgan Stanley will feel obliged to launch a similar fund so its wealthy clients don’t defect. Now, the chairmen of the Big Three automakers, despite all the criticism they have received recently, are presumably fairly rational, intelligent fellows who would rather coexist peaceably than get into damaging competition. (For now, we will set aside the mental capacities of Wall Street CEOs.)

I think it takes a toll on the people around me, which in turn takes a further toll on me.”
——
THE FIRST ACID TEST for Blankfein came on April 16, 2010, when, after a 3–2 vote along party lines, the SEC sued Goldman Sachs and one of its vice presidents for civil fraud as a result of creating, marketing, and facilitating, in 2007, a complex mortgage security—known as a synthetic CDO, or collateralized debt obligation—that was tied to the fate of the U.S. housing market. The CDO Goldman created was not composed of actual home mortgages but rather of a series of bets on how home mortgages would perform. While the architecture of the deal was highly complex, the idea behind it was a simple one: If the people who took out the mortgages continued to pay them off, the security would keep its value. If, on the other hand, home owners started defaulting on their mortgages, the security would lose value since investors would not get their contracted cash payments on the securities they bought.

…

Of course, Goldman had no intention of keeping the mortgages itself but rather bought them for the sole purpose of packaging them together and selling them off to investors for a fee determined by the difference between the price it paid for them and the price it sold them for. In other words, pretty standard Wall Street practice.
By the spring of 2006, Goldman was considered a respectable underwriter of mortgage-backed securities, ranking twelfth worldwide in 2005 in the underwriting of so-called structured finance deals—those for asset-backed securities, residential and commercial mortgage-backed securities, and collateralized debt obligations—worth $102.8 billion. By 2006, Goldman had moved up to tenth in the league tables—underwriting 204 deals globally, worth $130.7 billion—but still was far behind Lehman Brothers, Deutsche Bank, Citigroup, Merrill Lynch, and Bear Stearns. These other firms were coining money underwriting mortgage-backed securities and became so concerned about having access to a steady flow of mortgages to package up and sell that they all bought mortgage origination firms—Bear bought EMC Mortgage; Merrill bought First Franklin Financial Corp. from National City Bank in December 2006—at the top of the market—for $1.7 billion.

pages: 620words: 214,639

House of Cards: A Tale of Hubris and Wretched Excess on Wall Street
by
William D. Cohan

Unlike Greenberg, who kept his seat on the trading desk and the one as head of the risk committee and to some degree his finger on the pulse of the markets, Cayne had no more than an intuitive feel for the markets or for their growing complexity. For sure, he could decide when to buy or sell a stock, but when it came to understanding the calculus of and risks inherent in, say, a CDO-squared (that is, a collateralized debt obligation backed not by a pool of bonds and loans but by CDO tranches), well, that was a bridge too far. (In this, he was most certainly not alone among top Wall Street executives.) And, not surprisingly for a man who learned by listening and not by reading, he was no writer of notes of exhortation. In the Cayne regime, the quaint Greenberg memos slowly petered out. Instead, like Joe Torre in his Yankees heyday, Cayne preferred to believe he was managing a team of hand-picked superstars, and he expected them to perform.

…

From 1989 to 1991, Cioffi was the New York head of fixed-income sales and then, for the next three years, served as global product and sales manager for high-grade credit products. “He was involved in the creation of the structured credit effort at Bear Stearns and was a principal force behind Bear Stearns' position as a leading underwriter and secondary trader of structured finance securities, specifically collateralized debt obligations and esoteric asset-backed securities,” according to a description of him on file with the SEC.
“We all grew up with Ralph here,” explained Paul Friedman. “Ralph is one of the smartest guys I've ever met and was absolutely the best salesman I've ever met. When I was a trader, he was a salesman, a fabulous salesman. He was incredibly personable, incredibly smart, creative, and could get things done.”

…

“Every time Marin and the risk guys in BSAM would have a question with Ralph, Ralph would get Warren involved, and they'd all have this big meeting in Warren's office, and Warren would say to the BSAM, ‘You don't know what you're talking about. Leave Ralph alone. He's doing fine,' and eventually they came to largely ignore him. And that's a little harsh, but not entirely wrong, because none of them really understood what he did.” Explained Marin to the New York Times about Cioffi: “He had come up with an approach to trading those assets”—among others, mortgage-backed securities and collateralized debt obligations—“that people who are experts in that arena thought was a sound and interesting approach.”
BY 2003, HEDGE funds were the rage of global finance, much as private equity funds had been a decade or so earlier. Whereas the best and the brightest bankers on Wall Street left to become private equity dons, the best and the brightest traders on Wall Street left to become hedge fund managers.

Adaptive Markets: Financial Evolution at the Speed of Thought
by
Andrew W. Lo

Under normal conditions, if the narrative is flawed and the metaphorical Rapture doesn’t
occur on schedule, their counterparties will take their money without
a second thought. We may feel moral qualms about the particular
case of John Doe, but that’s because the narrative of our example has
Finance Behaving Badly
•
343
personalized him. He has a name and a motive; he’s been transformed
into a “YOU.”
Now let’s consider a financial setting. Imagine you’re the head of the
collateralized debt obligation desk at a major investment bank. You issue
collateralized debt obligations that, based on your proprietary models,
are likely to default, but your potential buyers believe otherwise, and
they’re eager to invest. As a broker-dealer of these instruments, is it ethical to sell them to these investors? Are you obligated to disclose your
proprietary models? Those models were developed through countless
research hours by dozens of highly trained financial analysts hired by
and paid for by your firm at a cost of millions of dollars.

…

So
let’s start with some basic facts.
298 • Chapter 9
FINANCIAL CRISIS 101
In the 1990s, a number of financial institutions besides traditional commercial banks began to participate in the housing market by underwriting mortgages directly to homeowners. These mortgage brokers
then sold the loans they originated to the secondary (resale) market,
where they were bought by government-sponsored enterprises like
Fannie Mae and Freddie Mac, or by investment banks, which used the
mortgages as raw material to create the alphabet-soup of new financial products such as ABSs (asset-backed securities) and CDOs (collateralized debt obligations).
This ecological change didn’t take place in a political or a cultural
vacuum. Politicians across the partisan spectrum encouraged mortgage
lending to a variety of different buyers, many of whom had never considered owning a home before. Home ownership became part of the
new American dream for more people. Lenders followed suit, and many
even loosened their lending standards, encouraged by the so-called
“ownership society” that a number of politicians espoused.

…

Lenders followed suit, and many
even loosened their lending standards, encouraged by the so-called
“ownership society” that a number of politicians espoused.
During this time, there was an enormous amount of financial evolution at the speed of thought. There was an adaptive radiation of new
mortgage types: adjustable-rate mortgages, “pick-a-payment” mortgages,
and even the infamous NINJA loan (“No Income, No Job, no Assets”),
evaluated and approved by automated loan-review programs. At the
same time, investment banks issued collateralized debt obligations,
which enabled large pools of mortgages to be packaged and chopped up
into a variety of new securities, and sold with the blessings of the rating
agencies. Ultimately, the credit default swap market emerged, in order
to provide insurance on some of those new debt issues, which encouraged even more investors to participate in the markets.
This process expanded the mortgage ecosystem’s size and reach.

But the CDS market was, as we now well know, egregiously mispriced by the humans who traded the swaps and set the prices. Nevertheless, Wall Street embraced Li’s formula as stone-solid fact. The copula should have been one arrow in the quiver of analysts and rating agencies who examined and stamped their approval on mortgage-backed securities. Instead, it became the only arrow.
The resultant boom in collateralized debt obligations and the housing market bubble came straight from bankers’ misuse of what should have been a harmless algorithm. Gaussian copulas are useful tools and are utilized in a number of fields, but the one thing they do not do is model dependence between extreme events, something humans excel at precipitating.33
PASCAL, BERNOULLI, AND THE DICE GAME THAT CHANGED THE WORLD
Much of modern finance, from annuities to insurance to algorithmic trading, has roots in probability theory—as do myriad other businesses from casinos to skyscraper construction to airplane manufacturing.

…

Wadhwa eventually got away and founded Relativity Technologies, which made software to help companies migrate from older code bases to newer ones such as C++ and Java. He has since become one of the leading voices of tech education from positions not only at Duke but also at Emory and Stanford.
As a new faculty member at Duke, Wadhwa watched as many of his brightest students ended up on Wall Street, conjuring up the very instruments that would lead the world to the brink of economic collapse—collateralized debt obligations, the Gaussian copula (a fine formula that was misused by the Street), and trading algorithms that could go wild at any moment.
This was in 2007, the all-time height of the stock market. Financial-sector companies were pulling in cash like a vacuum sucks dust. To ensure their spot at the top of the heap, the finance firms needed two things: friends in Washington and the best quantitative brains money could buy.

…

The rate among experienced engineers, in fact, dropped by more than 60 percent since the early 1980s, when Wall Street started snatching up technical minds as fast as it could.5
The authors, Paul Kedrosky and Dane Stangler, write:
The financial services industry used to consider it a point of pride to hire hungry and eager young high school and college graduates, planning to train them on the job in sales, trading, research, and investment banking. While that practice continues, even if in smaller numbers, the difference now is that most of the industry’s profits come from the creation, sales, and trading of complex products, like the collateralized debt obligations (CDOs) that played a central role in the recent financial crisis. These new products require significant financial engineering, often entailing the recruitment of master’s- and doctoral-level new graduates of science, engineering, math, and physics programs. Their talents have made them well-suited to the design of these complex instruments, in return for which they often make starting salaries five times or more what their salaries would have been had they stayed in their own fields and pursued employment with more tangible societal benefits.

They were also misled by the artificial economic environment created by the Federal Reserve. In addition, as discussed earlier, they had a significant economic incentive to rate the bonds as highly as possible to increase their revenues.
This is where the investment banks (Goldman Sachs, Morgan Stanley, Bear Stearns, Merrill Lynch, and Lehman Brothers) magnified the misallocation of credit to the housing market. They created a series of financial “innovations” (collateralized debt obligations [CDOs], derivatives, swaps, and others, which I discuss later) that leveraged an already overleveraged product.
The explanation typically given for these ultimately very bad decisions by investment bankers is greed. However, there was plenty of greed on Wall Street before the bubble. In fact, in my almost 40-year career in banking, there has always been greed on Wall Street. There was no more or less greed on Wall Street during the bubble.

…

You have probably flown on bankrupt airlines many times. It is true that financial institution bankruptcies are more complex and need to be planned in advance. Unfortunately, Lehman did not plan for a bankruptcy because it expected to be bailed out.
What was the nature of some of the more interesting derivatives—that is, the “innovations” in financial products? These instruments include CDOs (collateralized debt obligations), CDO2s, SIVs (structured investment vehicles), and other such products. Because of the complexity of the subject and the risk of confusion, let’s focus on a conceptually simplified example: CDOs.
CDOs have a reasonable history, as they were designed originally to reduce credit risk. A bank purchases a $500 million bond from General Electric. Even though General Electric is perceived to be a low risk, the bank does not want to have its risk this concentrated in one borrower, so it sells pieces of the bond totaling $400 million in the capital markets, which is a legitimate risk-management technique.

A DCF is also critical when there are limited (or no) “pure play” peer companies or comparable acquisitions.
Part Two: Leveraged Buyouts (Chapters 4 & 5)
Part Two focuses on leveraged buyouts, which comprised a large part of the capital markets and M&A landscape in the mid-2000s. This was due to the proliferation of private investment vehicles (e.g., private equity firms and hedge funds) and their considerable pools of capital, as well as structured credit vehicles (e.g., collateralized debt obligations). We begin with a discussion in Chapter 4 of the fundamentals of LBOs, including an overview of key participants, characteristics of a strong LBO candidate, economics of an LBO, exit strategies, and key financing sources and terms. Once this framework is established, we apply our step-by-step how-to approach in Chapter 5 to construct a comprehensive LBO model and perform an LBO analysis for ValueCo.

…

Although there is often overlap between them, traditional bank lenders provide capital for revolvers and amortizing term loans, while institutional lenders provide capital for longer tenored, limited amortization term loans. Bank lenders typically consist of commercial banks, savings and loan institutions, finance companies, and the investment banks serving as arrangers. The institutional lender base is largely comprised of hedge funds, pension funds, prime funds, insurance companies, and structured vehicles such as collateralized debt obligation funds (CDOs).124
Like investment banks, lenders perform due diligence and undergo an internal credit process before participating in an LBO financing. This involves analyzing the target’s business and credit profile (with a focus on projected cash flow generation and credit statistics) to gain comfort that they will receive full future interest payments and principal repayment at maturity.

The Fed was hardly alone in taking these preparatory measures. Numerous other central banks, and the International Monetary Fund, had been regularly publishing “financial stability reports” to highlight potential crisis threats. All suffered from the same problem: ignorance of the risks then propagating in the shadows of the financial system. The Fed knew that subprime mortgages and more exotic instruments such as collateralized debt obligations and credit default swaps existed, but as one study later found, rarely did any of these seem important enough to be mentioned in monetary policy makers’ regular meetings.
So, by 2007, there was widespread awareness that homes were probably overvalued but little concern that this would produce a systemic crisis. Twenty-five years of experience and reform had moved most of the risks out of the banking system, provided new tools such as secured repo loans to contain risks, and slain inflation, the single biggest threat to financial stability anyone alive had ever known.

…

As mortgages were repaid, money went first to the owner of the top tranche. If any mortgages defaulted, it was the lowest tranches that took the loss. This meant that it would take a cataclysmic level of defaults before the top tranches sustained any losses. Those tranches were deemed so safe they deserved the highest credit ratings available: AAA or AA. Tranches were often pooled into a new security called a collateralized debt obligation (CDO), which was, itself, then sliced into tranches. AIG made a point of selling protection only on the highest-rated tranches of MBSs and CDOs.
By 2006, AIGFP had begun to worry enough about the quality of underwriting that it stopped selling protection on subprime-backed MBSs and CDOs. Cracks appeared in the system as indexes tied to subprime mortgages began to fall. By 2007, those cracks spread and began to show in the market.

…

By walling off some of that supply, Goldman indirectly forces everyone else to hold less, and to hold riskier paper instead. This strategy, in other words, works if only Goldman follows it, but not if everyone does.
Goldman protected itself from the subprime collapse in a similar way. It was a major player in the subprime frenzy, originating $100 billion in mortgage-backed securities and related collateralized debt obligations in 2006 and 2007. But at the end of 2006 it became nervous and decided to cut its exposure, and in early 2007 it switched to a short position, in other words a position that would go up in value if mortgage-backed securities fell.
A few years earlier, Goldman and several other banks spotted a problem in the mortgage market. If you held a big position in stocks, you could protect yourself against a drop with an option or a futures contract.

We also want to acknowledge the enormous patience of our families while we
struggle away at the computer, now and always: Sarah, Robin and William (David’s
family) and Rachel and Scarlett (Andrew’s family). Without them we couldn’t manage
it or be who we are today.
David Boyle
Andrew Simms
List of Acronyms and Abbreviations
CDCU
CDFI
CDO
CEO
CHP
CND
Democs
DIY
DTQ
EBCU
Escos
GDP
GM
GPI
HPI
IMF
IP
ISEW
km
Lets
LM3
m
MDGs
MDP
MDR-TB
mph
nef
NHS
RESOLVE
SDRs
community development credit union
community development finance institution
collateralized debt obligation
chief executive officer
combined heat and power
Campaign for Nuclear Disarmament
deliberative meeting of citizens
do-it-yourself
domestic tradable quota
emissions-backed currency unit
energy service companies
gross domestic product
genetically modified
Genuine Progress Indicator
Happy Planet Index
International Monetary Fund
intellectual property
Index of Sustainable Economic Welfare
kilometre
Local exchange and trading systems
Local Money 3
metre
Millennium Development Goals
Measure of Domestic Progress
multi-drug resistant tuberculosis
miles per hour
New Economics Foundation
National Health Service
Research Group on Lifestyles Values and Environment
special drawing rights
xii
SERs
SIV
SROI
T-bills
TEQ
TOES
TRIPS
WEEE
THE NEW ECONOMICS
special emission rights
structured investment vehicle
social return on investment
Treasury bills
tradeable emissions quota
The Other Economic Summit
Trade-Related Aspects of Intellectual Property
Waste Electrical and Electronic Equipment (Directive)
1
The Economic Problem
Man talks of a battle with nature, forgetting that if he won the battle,
he would find himself on the losing side.

…

Then they could lend money from the sale to more investors and so on.
The disastrous model used by so many lenders meant bundling up their mortgages
and selling them on, then using the proceeds to lend more. It meant that banks and
other investors would buy the SIVs, getting the full value of the repayments over the
years. The SIVs were then taken apart and reassembled into parcels called collateralized debt obligations (CDOs) and sold to hedge funds, which sold them on all over
the world. Because these CDOs included debts from a range of different markets, they
were believed to be insulated against risk: the mortgages might cause problems, but
the other loans would offset the risk. That is how the credit ratings agencies Moodys
and Standard & Poor saw it, giving them AAA ratings.
6
THE NEW ECONOMICS
The trouble was that, once the truth about the sub-prime loans – M.

Between 2007 and 2012,
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Taking Progress for Granted
approaching 500 US banks had failed (including the aptly named
Cape Fear Bank in Wilmington, North Carolina). That compared
with only 24 failures in the previous six years.17
Capital markets ultimately are responsible for linking savers with
investors. Yet the financial crisis revealed that the linkages were often
tenuous – person A put her savings in pension fund B, which then
purchased a bundle of pieces of paper known as collateralized
debt obligations from bank C, which had assembled the bundle
via investments in mortgage-­backed securities – some of dubious
quality – issued by banks D, E and F, which, in turn, had used the
money raised to lend to homebuyers G, H and I, one or more of
whom had a dubious credit history and, hence, was ‘subprime’.
Person A had no direct connection with the homebuyers – indeed,
the saver was likely to be thousands of miles away from the ultimate
borrower – but the indirect connection was there, nevertheless.

…

Based on our collective belief in continuously rising living
standards, we have spent the last half-­century watching our financial
wealth and our political and economic ‘rights’ accumulate at an
incredible pace. We all, directly or indirectly, own pieces of paper
or rely on political promises that make claims on future economic
prosperity. The pieces of paper range from cash through to government bonds, from equities through to property deeds and from
asset-­backed securities through to collateralized debt obligations.
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Taking Progress for Granted
The language deployed may vary from the very simple to the incredibly complicated but these pieces of paper all have one thing in
common: they represent claims on assumed future economic success.
They are all manifestations of the same act of faith: namely that the
future will be better than the present and vastly superior to the past.

…

As
property portfolios went belly up, some institutions found access to
the interbank market – the market that, on a daily basis, allows banks
to deal with liquidity shortfalls and excesses – increasingly difficult.
And, as interbank rates rose, so equity investors sold even more
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Loss of Trust, Loss of Growth
shares, believing that those operating in the interbank market might
have had ‘inside knowledge’ of the state of an individual bank’s
solvency. Meanwhile, the underlying investors who now owned huge
amounts of collateralized debt obligations and the like began to
realize they were sitting on a pile of toxic waste: and without the
appetite to buy more of the stuff, banks lost a key source of funding
for lending. Credit creation came to a grinding halt and so, too, did
Western economies.
This was yet another example of an age-­old banking problem. No
bank ever has sufficient funds immediately available to be able to
return cash to all of its depositors at once.

One has to do with the sales pitch of Tea Party rhetoric, which cleverly exploits Main Street frustrations over genuinely intrusive state and local governments that are constantly in the pockets of small businesses for fees and fines and permits.
The other reason is obvious: the bubble economy is hard as hell to understand. To even have a chance at grasping how it works, you need to commit large chunks of time to learning about things like securitization, credit default swaps, collateralized debt obligations, etc., stuff that’s fiendishly complicated and that if ingested too quickly can feature a truly toxic boredom factor.
So long as this stuff is not widely understood by the public, the Grifter class is going to skate on almost anything it does—because the tendency of most voters, in particular conservative voters, is to assume that Wall Street makes its money engaging in normal capitalist business and that any attempt to restrain that sector of the economy is thinly disguised socialism.

…

Even as she spends every day publicly flubbing political SAT questions, she’s always dead-on when it comes to her basic message, which is that government is always the problem and there are no issues the country has that can’t be worked out with basic common sense (there’s a reason why many Tea Party groups are called “Common Sense Patriots” and rally behind “common sense campaigns”).
Common sense sounds great, but if you’re too lazy to penetrate the mysteries of carbon dioxide—if you haven’t mastered the whole concept of breathing by the time you’re old enough to serve in the U.S. Congress—you’re not going to get the credit default swap, the synthetic collateralized debt obligation, the interest rate swap. And understanding these instruments and how they were used (or misused) is the difference between perceiving how Wall Street made its money in the last decades as normal capitalist business and seeing the truth of what it often was instead, which was simple fraud and crime. It’s not an accident that Bachmann emerged in the summer of 2010 (right as she was forming the House Tea Party Caucus) as one of the fiercest opponents of financial regulatory reform; her primary complaint with the deeply flawed reform bill sponsored by Senator Chris Dodd and Congressman Barney Frank was that it would “end free checking accounts.”

…

Despite these legally questionable efforts of Rubin and Greenspan, Born did eventually release her paper on May 7 of that year, but to no avail; Greenspan et al. eventually succeeded not only in unseating Born from the CFTC the next year, but in passing a monstrosity called the Commodity Futures Modernization Act of 2000, which affirmatively deregulated the derivatives market.
The new law, which Greenspan pushed aggressively, not only prevented the federal government from regulating instruments like collateralized debt obligations and credit default swaps, it even prevented the states from regulating them using gaming laws—which otherwise might easily have applied, since so many of these new financial wagers were indistinguishable from racetrack bets.
The amazing thing about the CFMA was that it was passed immediately after the Long-Term Capital Management disaster, a potent and obvious example of the destructive potential inherent in an unregulated derivatives market.

Although B, G and M have their names associated with this idea many others worked on it simultaneously.
2000 Li As already mentioned, the 1990s saw an explosion in the number of credit instruments available, and also in the growth of derivatives with multiple underlyings. It’s not a great step to imagine contracts depending of the default of many underlyings. Examples of these are the ubiquitous Collateralized Debt Obligations (CDOs). But to price such complicated instruments requires a model for the interaction of many companies during the process of default. A probabilistic approach based on copulas was proposed by David Li (2000). The copula approach allows one to join together (hence the word ‘copula’) default models for individual companies in isolation to make a model for the probabilities of their joint default.

…

Constant Maturity Swap (CMS) is a fixed-income swap. In the vanilla swap the floating leg is a rate with the same maturity as the period between payments. However, in the CMS the floating leg is of longer maturity. This apparently trivial difference turns the swap from a simple instrument, one that can be valued in terms of bonds without resort to any model, into a model-dependent instrument.
Collateralized Debt Obligation (CDO) is a pool of debt instruments securitized into one financial instrument. The pool may consist of hundreds of individual debt instruments. They are exposed to credit risk, as well as interest risk, of the underlying instruments. CDOs are issued in several tranches which divide up the pool of debt into instruments with varying degrees of exposure to credit risk. One can buy different tranches so as to gain exposure to different levels of loss.

…

The pricing of these contracts requires a model for the relationship between the defaults in each of the underlying instruments. A common approach is to use copulas. However, because of the potentially large number of parameters needed to represent the relationship between underlyings, the correlations, it is also common to make simplifying assumptions. Such simplifications might be to assume a single common random factor representing default, and a single parameter representing all correlations.
Collateralized Debt Obligation Squared (CDO2) is a CDO-like contract in which the underlyings are other CDOs instead of being the simpler risky bonds.
Collateralized Mortgage Obligation (CMO) is a pool of mortgages securitized into one financial instrument. As with CDOs there are different tranches allowing investors to participate in different parts of the cashflows. The cashflows in a mortgage are interest and principal, and the CMOs may participate in either or both of these depending on the structure.

The deals with Goldman had gone down in a matter of months and required the efforts of just a few geeks on a Goldman bond trading desk and a Goldman salesman named Andrew Davilman, who, for his services, soon would be promoted to managing director. The Goldman traders had booked profits of somewhere between $1.5 billion and $3 billion--even by bond market standards, a breathtaking sum.
In the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans. Its logic was exactly that of the original mortgage bonds. In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose.

…

He'd draw a picture of several towers of debt. The first tower was the original subprime loans that had been piled together. At the top of this tower was the triple-A tranche, just below it the double-A tranche, and so on down to the riskiest, triple-B tranche--the bonds Eisman had bet against. The Wall Street firms had taken these triple-B tranches--the worst of the worst--to build yet another tower of bonds: a CDO. A collateralized debt obligation. The reason they'd done this is that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce 80 percent of the bonds in it triple-A. These bonds could then be sold to investors--pension funds, insurance companies--which were allowed to invest only in highly rated securities. It came as news to Eisman that this ship of doom was piloted by Wing Chau and people like him.

…

In turn this suggested what Grant already knew, that far too many people were taking far too many financial statements on faith. In early 2007 Grant wrote a series of pieces suggesting that the rating agencies had abandoned their posts--that they were almost surely rating these CDOs without themselves knowing exactly what was inside them. "The readers of Grant's have seen for themselves how a stack of non-investment grade mortgage slices can be rearranged to form a collateral debt obligation," one piece began. "And they have stared in amazement at the improvements that this mysterious process can effect in the credit ratings of the slices..." For his troubles, Grant, along with his trusted assistant, was called into S&P for a dressing-down. "We were actually summoned to the rating agency and told, 'You guys just don't get it,'" says Gertner. "Jim used the term 'alchemy' and they didn't like that term."

pages: 354words: 92,470

Grave New World: The End of Globalization, the Return of History
by
Stephen D. King

But Basel I was indifferent about the quality of lending within asset classes (prompting profit-maximizing banks to lend more in any one category to riskier customers, who would pay higher interest rate spreads) and it was overly dependent on the judgements of ratings agencies, which, on too many occasions, had no more understanding of the inherent riskiness of innovative financial assets – collateralized debt obligations, for example – than anybody else. The architects of Basel II, produced in 2004 but still not fully implemented as the global financial crisis got going, were more sceptical about the value that ratings agencies could add. Yet, remarkably, they preferred to rely on banks’ own internal risk models to gauge the riskiness of the activities banks were engaged in. Even without the inevitable conflict of interest this approach was still problematic: whether the models were internally constructed or independently generated, they were typically based on too limited a time period and thus said very little about the robustness of a particular institution in the event of, for example, a housing meltdown.

…

It stemmed from a combination of factors, each of which challenged what had become conventional thinking over the previous three decades.
Markets themselves were failing, thanks in part to asymmetric information: the ultimate investors in US sub-prime mortgages were often blissfully unaware of the risks they were taking, largely because the underlying nature of their risky investments was typically camouflaged through the copious use of collateralized debt obligations and other innovative financial ‘disguises’.15
Incentives were badly skewed: those who made commission from selling risky products were typically able to pass the risk on to others – often thousands of miles away – using ‘pile ’em high and sell ’em cheap’ tactics.
Excessive Chinese savings, a reflection of a poorly functioning domestic capital market, found their way into the US Treasury market, reducing the yield on treasuries and thus encouraging others to hunt for higher returns on – inevitably riskier – assets.

…

Recall from Chapter 4 that the ratio of foreign-held capital as a share of global income rose from little more than 5 per cent at the end of the Second World War to well over 200 per cent by the time of the global financial crisis, with much of the increase coming in the 1980s and beyond. In effect, there are now massive cross-border economic and financial claims made up of a vast number of pieces of paper and entries in electronic ledgers. Because these claims relate to capital markets, they essentially operate through time and space: when, for example, a German Landesbank buys a US collateralized debt obligation (CDO), it is essentially making a – legal – claim on future US economic output. The interest rate paid by the US issuer of the CDO to its proud owner will, in turn, reflect a combination of reward for consumption forgone, the perceived ‘riskiness’ of the underlying borrowers (to be precise, the danger that the borrowers will not be able to repay the principal in full), and the liquidity of the CDO (in other words, the ease with which it can be converted quickly into cash at little cost).

Pension funds and other investors could buy securitized products tailored for the cash flow and risk characteristics they wanted. The distribution of the securities beyond U.S. banks to investors around the world acted as a buffer by spreading risks wider than the banking system.
But there was a dark side. The market became opaque as structured products grew increasingly complex and difficult to understand even for sophisticated investors. Collateralized debt obligations, or CDOs, were created to carve up mortgages and other debt instruments into increasingly exotic components, or tranches, with a wide variety of payment and risk characteristics. Before long, financial engineers were creating CDOs out of other CDOs—or CDOs-squared.
Lacking the ability of traditional lenders to examine the credit quality of the loans underlying these securities, investors relied on rating agencies—which employed statistical analyses rather than detailed studies of individual borrowers—to rate the structured products.

…

It was the smallest of the big five investment banks, after Goldman Sachs, Morgan Stanley, Merrill Lynch, and Lehman Brothers. And while Bear hadn’t posted the massive losses of some of its rivals, its huge exposure to bonds and mortgages made it vulnerable. Bear had found itself in increasingly difficult straits since the previous summer, when, in one of the first signs of the impending crisis, it had been forced to shut down two hedge funds heavily invested in collateralized debt obligations.
For all that, I also knew Bear as a scrappy firm that liked to do things its own way: alone on Wall Street it had refused to help rescue Long-Term Capital Management in 1998. Bear’s people were survivors. They had always seemed to find a way out of trouble.
For months, Steel and I had been pushing Bear, and many other investment banks and commercial banks, to raise capital and to improve their liquidity positions.

…

Jeff was following up on a phone call from the week before when, just after the takeovers of Fannie Mae and Freddie Mac, he’d mentioned that GE was having problems in the commercial paper market. His report had alarmed me then. That market had been in distress since the onset of the credit crisis in August 2007. The worst of that had involved the asset-backed commercial paper market, which supported all those off-balance-sheet special investment vehicles filled with toxic collateralized debt obligations that banks had cooked up. I’d never expected to hear those troubles spreading like this to the corporate world, and certainly not to GE.
Commercial paper is essentially an IOU that is priced on the credit rating of the borrower and generally backstopped by a bank line of credit. It’s usually issued for short periods of time—90 days or less. And it’s often bought by money market funds looking for a safe place to get a higher rate of return than they would earn from short-term government bills.

But if a thousand subprime mortgages, each worth about $250,000, were pooled together and turned into a single security with a collective value of $250 million, the security could be divided into some number of shares. The potential loss caused by any one mortgage going into default would be offset by the fact that it represented only a tiny portion of the security’s total value.
Parts of the securities, in many cases the lowest on the food chain, were often bundled into even more esoteric monstrosities known as collateralized debt obligations, which took into account the fact that some of the underlying mortgages were more likely than others to default. The more-likely-to-default bundles obviously carried greater risk, though along with that came its corollary, greater potential reward. Between 2004 and 2007, billions in subprime home loans were stuffed into these so-called CDOs. The CDOs were then sliced into tranches. There were high-quality slices, stamped AAA by rating agencies such as Standard & Poor’s, and there were poor-quality slices, some of which were so low in quality they didn’t even get a rating.

…

Often these investors never actually held the debt in the first place. Instead, they were gambling on the perception of whether a company would default or not.
If all of this weren’t strange enough, things became truly surreal when the world of credit default swaps met the world of securitization. Brown had watched, with some horror, as banks started to bundle securitized loans into a product they called a collateralized debt obligation, or CDO. CDOs were similar to the CMOs (collateralized mortgage obligations) Brown had encountered in the 1980s. But they were more diverse and could be used to package any kind of debt, from mortgages to student loans to credit card debt. Some CDOs were made up of other pieces of CDOs, a Frankenstein-like beast known as CDO-squared. (Eventually there were even CDOs of CDOs of CDOs.)

…

His testimony provided little insight into the problems behind the meltdown, though it did offer a rare glimpse into Renaissance’s trading methods.
“Renaissance is a somewhat atypical investment management firm,” he said. “Our approach is driven by my background as a mathematician. We manage funds whose trading is determined by mathematical formulas. … We operate only in highly liquid publicly traded securities, meaning we don’t trade in credit default swaps or collateralized debt obligations. Our trading models tend to be contrarian, buying stocks recently out of favor and selling those recently in favor.”
For his part, Griffin sounded a note of defiance, fixing his unblinking blue eyes on the befuddled array of legislators. Hedge funds weren’t behind the meltdown, he said. Heavily regulated banks were.
“We haven’t seen hedge funds as the focal point of the carnage in this financial tsunami,” said Griffin, clad in a dark blue jacket, black tie, and light blue shirt.

See credit/credit market; finance/financial markets; housing market; stock market
Maughan, Deryck
Mayo, Michael
MBIA
MDC Holdings
Meltzer, Allan
Merkel, Angela
Merrill Lynch
Bank of America’s negotiations with and acquisition of
Bear Stearns and
Ben Bernanke and
board of
capital raised by
CDOs and
change of leadership at
come-to-Jesus moment for
compensation at
concern over
Jamie Dimon and
efforts to sell
failure to pull back from mortgage-backed securities
First Franklin acquired by
Goldman Sachs and
job losses at
JPMorgan Chase and
leverage of
losses
Morgan Stanley and
mortgage bubble and
Hank Paulson and
stock price of
Stuyvesant Town sale and
Wachovia and
Miller, Harvey
Minsky, Hyman
Mitsubishi UFJ
money market crisis
Ben Bernanke and
Timothy Geithner and
Lehman’s bankruptcy and
Hank Paulson and
Money Store
Montag, Peter
Moody, John
Moody’s
AIG and
Lehman Brothers and
moral hazard
Morgan Stanley
AIG and
as bank holding company
capital sought by
credit default swaps and
Timothy Geithner and
government efforts to arrange a merger for
hedge funds and
history of
insurance (credit default swap) premiums of
job losses at
JPMorgan Chase and
leverage
Merrill Lynch and
Mitsubishi and
panic and
Hank Paulson and
rumors about
short selling against
stock price of
John Thain and
Wachovia and
mortgage-backed securities
BBB rated
Bear Stearns and
checks on
capital level for
collapse of market for
collateralized debt obligations. See collateralized debt obligations (CDOs)
cooling of market for
credit rating agencies and
example of
fall in prices of
foreign-held
Goldman Sachs and
growth of
insurance claims on
Lehman Brothers and
Merrill Lynch and
mortgage bubble and
payment waterfall
prime
risk taking and
subprime mortgages and
swimming pool metaphor for
total amount floated in
mortgage banking, as race to the bottom
mortgage bubble
banking regulators and
banks’ late stage desperation in
bursting of
Citigroup and
credit and
developing disaster, evidence of
Federal Reserve’s role in
Freddie Mac and Fannie Mae and
mass hallucination in
Merrill Lynch and
mortgage securitization and
reasons for
ripple effect of
Wall Street and
Washington Mutual and
mortgage lenders.

…

If an investment bank assembled a package that, in its totality, was too risky, the investors would balk, and the bank would be stuck holding the BBB paper itself. This the bank did not want. Therefore, the presence of discriminating investors served as a check on the entire process.
In the early 2000s, this delicate equilibrium was upset by a new, less-discriminating class of investor. These investors were collateralized debt obligations. CDOs were dummy corporations—legal fictions organized for the purpose of buying and selling bonds. Engineered by Wall Street banks and similar operators, the CDO introduced a second level of securitization. Instead of buying mortgages directly, the CDO was a security that invested in other, first-order securities that themselves had acquired mortgages. The CDO thus introduced an additional layer into the process, with the result that the ultimate investor was further removed, and less equipped to scrutinize, the quality of the underlying mortgages.

We didn’t manufacture much anymore, but we could sure dream up awesome ways to securitize debt and slice up the risk in every imaginable situation. One testament to the zesty innovativeness of markets was the industry that had sprung up to supply credit to “subprime” borrowers, selling off the loans thus made to the investment banking industry on Wall Street. Then there were the geniuses at the next few steps of the process, who bundled those subprime mortgages into bonds and those bonds into collateralized debt obligations—and then sold credit default swaps to insure against the possibility of their failure.2
The gospel of deregulation, meanwhile, had become such an irresistible ideological juggernaut that no amount of real-world failure could call it into question. Under the guidance of this doctrine, our leaders removed certain derivatives from regulatory oversight; they watered down requirements that banks balance their risk with safe assets; they exempted credit default swaps from regulation as insurance products; they dialed back the Federal Reserve’s regulatory powers; and they struck down a rule that required hedge-fund advisers to register with the Securities and Exchange Commission.

…

They wouldn’t encourage it through artificially low interest rates, Fannie and Freddie, tax breaks, or a “Community Reinvestment Act,” but they wouldn’t discourage it either.* Rates would be set by market participants, based on risk, reward, and a clear understanding that making bad loans would result in bankruptcy.†
Do you see how awesome that would be, reader? Without regulation, everyone would live in harmony with nature and the intent of the Founders, and nothing like collateralized debt obligations would ever be invented. Bubbles would never happen. Bankers would never build systems that rewarded them for making bad loans—their rational self-interest wouldn’t let them! To get back to Beck:
But we’ve done the complete opposite of that. The housing market is manipulated by the government every step of the way. So while some may argue that we need more regulation to prevent those future “excesses,” I would argue that it’s the existing regulations that created those excesses in the first place.

These funds may also utilize derivatives to leverage returns and
to hedge out interest rate and/or market risk. Because they invest in special situations,
the performance of these funds is typically not dependent on the direction of the public stock market. Note: This is primarily an equity-based style.
Fixed Income Strategies
There are many different fixed income funds that invest in various types of debt
instruments, including mortgage-backed securities (MBS), collateralized debt obligations (CDOs), collateralized loan obligations (CLOs), convertible bonds, high-yield
bonds, municipal bonds, corporate bonds, and different types of global securities.
There are diversified funds that may invest in a combination of these securities and
also arbitrage funds that seek to profit by exploiting pricing inefficiencies between
related fixed income securities while neutralizing exposure to interest rate risk.

…

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Operations
101
Although pedigree is not as important, funds will pay close attention to undergraduate
and graduate school GPAs and SAT scores and want to see excellence in both areas.
In addition to academics, hedge funds look for specific product knowledge and will
pay up for experience in the more sophisticated products such as derivatives, credit
default swaps (CDS), collateralized debt obligations (CDOs), and collateralized loan
obligations (CLOs).
As with other hedge fund roles, it’s good to know the different hedge fund investment strategies. Hedge funds can be extremely picky when hiring, so whatever you
can do to differentiate yourself and show you have additional skills will be helpful. We
strongly suggest being very well versed in industry-specific systems. For example, if you
are working in trade support or accounting you should get to know Advent/Axys, and
if you are working with equities you will want to be proficient in trade support systems
such as Eze Castle.

…

Just
when I began the firm was creating an alternative investment group, and, luckily for me,
I was placed into it. Right off the bat I got exposure to hedge funds. In fact, my first onsite audit was with a fund that specialized in mortgage-backed securities. Even though I
worked like a dog and didn’t have much of a life, I gained a working knowledge of products, including mortgage-backed securities, collateralized debt obligations (CDOs), swaps,
repurchase agreements, equities, and bonds. The job also opened my eyes to other opportunities and made me want to work doing investment banking or sales and trading.
I wasn’t a big fan of the huge corporate atmosphere of the Big Four firms (they
work you to the bone without the bonuses of investment banks), and after a couple of
years I began to look at other opportunities.

Finance has not, and cannot, create
Conclusions 181
a crystal ball to foresee the future. The world is uncertain because we
never know how markets, economies, resources, or institutions will be
abused or used in ways that could not have been broadly anticipated.
The failure of Long Term Capital Management in 1999 and the credit
crisis of 2008 brought about by a freezing-up of the derivatives market
in credit default swaps and collateralized debt obligations demonstrates
that, while risk can be hedged, it can never be reduced to zero.
Notes
1
Introduction
1. John Maynard Keynes, “The General Theory of Employment,” Quarterly
Journal of Economics, 51 (1937), 209–23, at p. 214.
3 The Early Years
1. www.newschool.edu/nssr/het/profiles/neisser.htm, date accessed January 23,
2012.
2. A. Cowles, “Can Stock Market Forecasters Forecast?” Econometrica, 1 (1933),
309–24.
5
The Theory
1.

…

Chicago Board of Trade (CBOT) – a commodity exchange established in 1848
that permitted the trading of financial and commodity contracts.
Chicago School – a philosophy of economic and financial thought based on the
premise that unfettered markets are the most efficient.
Classical model – a microeconomic-based approach to economic decisionmaking that assumes that all actors are rational and maximize their selfinterest, and is driven by the principle that prices adjust to ensure supply is
equal to demand.
Collateralized debt obligations – investment-grade securities backed by a package
of loans, mortgages, bonds, or other debt obligations.
188
Glossary 189
Consumption CAPM – an extension of the CAPM that includes future consumption
preferences.
Corporate finance – the study of financial decisions made by corporations to
maximize shareholder value.
Correlation – the statistical relationship between two variables, typically
measured by demonstrating that the movement of one variable is associated
with movement of the other.

Alan Greenspan, as Chairman of the Federal Reserve from 1987 to 2006, had presided over the financial revolution, globalization and the long boom. He believed in free markets and had accepted the theories emanating from the Chicago School of economics. Once the boom collapsed, he recanted. In his testimony to a committee of the US House of Representatives, he explained what happened. The exposition is illuminating:
It was the failure to properly price such risky assets [mortgage backed securities and collateral debt obligations] that precipitated the crisis. In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts, supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivative markets. This modern risk management paradigm held sway for decades.

…

There were more forex, bonds and equity markets now for the investors to put their money into. The market economy was globalized in other ways as well. The WTO was established, capital flows to developing economies accelerated and many governments began to borrow on global financial markets. Activities on the financial front exploded as many new stock markets opened up and many new instruments were innovated: credit default swaps (CDS) and collateralized debt obligations (CDO) being lately the most notorious. Much of this was the consequence of the pioneering work of Black and Scholes on options. Hedge funds and many other institutions of what became known as the shadow banking structure also proliferated. Transactions on the forex markets reached a level of trillions of dollars. (The collapse of Long-Term Capital Management, which invested in foreign bonds, was one example of the collateral damage caused by the implosion in global financial markets.)

We use the term mortgage-related securities for a broad class of securities containing not only mortgage-backed securities (MBS) but also securities resulting from the securitization of MBS. MBS themselves might serve as collateral for collateralized debt obligations (CDOs) (see, for example, Das 2010, Chapter 9). The idea and the procedure are the same as those for the creation of a mortgage-backed security out of a package of mortgages except that the collateral consists of MBS or more general asset-backed securities (ABS) rather than mortgages. The resulting MBS CDOs or, more generally, ABS CDOs—collateralized debt obligations with MBS or ABS as collateral—might even be securitized further to create ABS CDOs2, CDOs whose collateral consists of ABS CDOs. For the loss estimates, see IMF (2008b). The estimated total losses of financial institutions from the financial crisis in this report are higher than just the losses on subprime-mortgage-related securities ($1.4 trillion), but this larger estimate already includes significant follow-on losses.
3.

…

At each stage, a package of junior (“mezzanine”) claims, with low credit ratings of BBB or worse, would be formed, and new claims, with different priorities, would be issued against the returns from this package. Under the assumption that credit risks on the different securities in a package of mezzanine mortgage-backed securities (MBS) were independent, the senior MBS collateralized debt obligations (CDOs) would be treated as almost riskless and given ratings of AAA. However, the assumption of independence of credit risks was unwarranted because all of the underlying mortgages depended on the factors driving U.S. real estate markets, such as the overall economy, the interest rate policy of the Federal Reserve, and the real estate bubble itself. McLean and Nocera (2010, 362) sarcastically ask: “Collateralized debt obligation? Synthetic securities? What had been the point of that?” The point was that banks responded to flawed regulations in their own interest; their actions had little to do with efficiency.
72.

But LTCM’s lenders were mostly caught unaware because the hedge funds were not required to make their loan positions known. In 1999, when arguing against the proposal of the head of the Commodities Futures Trading Commission to regulate financial derivatives, Greenspan claimed that unrestricted derivatives trading would stabilize finance, not disrupt it. He had no idea how dangerous the new mortgage-based collateralized debt obligations were, as we shall see, the principal source of overly risky investment in the 2000s. It never occurred to him that investment banks were now creating loans just like the commercial banks he oversaw, but this shadow banking system was not regulated by the one agency designed to make sure U.S. credit was strong, his own.
Writing a letter in support of Keating, apart from the outrageous irresponsibility and suspiciously easy payday, was simply an ideological reflex of his at work.

…

Greenspan, based on his firm market principles, approved strongly of securitization and most derivative products as a way to spread risk—a view traditional market economists like Summers shared. But even when crisis struck in 2008, it was clear the Federal Reserve economists in Washington and New York did not understand how excessive and risky the borrowing now was. In particular, the relatively new collateralized debt obligations (CDOs), a way of packaging risky mortgages for investors willing to make only low-risk investments, was not understood or even investigated. Greenspan’s ultimately naive and dangerous faith in competitive markets showed itself nowhere as damagingly as in the Fed’s failure to be vigilant about the CDOs. Not only did his interest rate increases fail to dampen the financing, but they encouraged Wall Street to take more risks and mortgage brokers to write more bad loans because their profit margins had narrowed.

Mortgage Securitization
The next step in the mortgage lending process, as we have seen, is that the mortgage
originators sell their individual mortgages to a mortgage securitizer so that they can be
bundled into a form that will allow them to be placed in investor portfolios. At this
point there has often been another step in the process. The RMBSs will in turn be placed
into a trust to allow a set of collateralized debt obligations (CDOs) to be issued based on
the mortgage pool. The CDOs are divided up into pieces known as tranches, according
to the perceived repayment ability of the holders of the underlying mortgages; in case of
default on some of those mortgages, the senior tranche is paid rst, followed by the
second tranche, the third tranche, and so on. The various tranches, with their di erent
levels of risk and accordingly varying pricing, are designed to appeal to di erent kinds
of investors.

In the manic days of 2002 to 2006, millions of Americans came to rely on soaring real estate values as a source of income, turning their houses into ATMs (to use once more the phrase heard so often then). As long as prices kept going up, homeowners felt justified in borrowing to remodel a kitchen or bathroom, and banks felt fine making those loans. Meanwhile, the wizards of Wall Street were finding ways of slicing and dicing sub-prime mortgages into tasty collateralized debt obligations that could be sold at a premium to investors — with little or no risk! After all, real estate values were destined to just keep going up. God’s not making any more land, went the truism.
Credit and debt expanded in the euphoria of easy money. All this giddy optimism led to a growth of jobs in construction and real estate industries, masking underlying ongoing job losses in manufacturing.

…

Nearly everyone agrees that it unfolded in essentially the following steps:
• In an attempt to limit the consequences of the “dot-com” crash of 2000, the Federal Reserve drastically lowered interest rates, enabling lenders across the country to provide easy credit to households and businesses who hadn’t been able to access it before.
• This led to a housing bubble, which was made much worse by sub-prime lending.
• Partly because of the prior deregulation of the financial industry, the housing bubble was also magnified by over-leveraging within the financial services industry, which was in turn exacerbated by financial innovation and complexity (including the use of derivatives, collateralized debt obligations, and a dizzying variety of related investment instruments) — all feeding the boom of a shadow banking system, whose potential problems were hidden by incorrect pricing of risk by ratings agencies.
• A commodities boom (which drove up gasoline and food prices) and temporarily rising interest rates (especially on adjustable-rate mortgages) ultimately undermined consumer spending and confidence, helping to burst the housing bubble — which, once it started to deflate, set in motion a chain reaction of defaults and bankruptcies.

…

Decades earlier, bond credit ratings agencies had been paid for their work by investors who wanted impartial information on the credit worthiness of securities issuers and their offerings. Starting in the early 1970s, the “Big Three” ratings agencies (Standard & Poor’s, Moody’s, and Fitch) began to be paid instead by securities issuers. This eventually led to ratings agencies actively encouraging the issuance of high-risk collateralized debt obligations (CDOs).
Also in the 1990s, the Clinton administration adopted “affordable housing” as one of its explicit goals (this didn’t mean lowering house prices; it meant helping Americans get into debt), and over the next decade the percentage of Americans owning their homes increased 7.8 percent. This initiated a persistent upward trend in real estate prices.
The Internet as we know it today opened for business in the mid-1990s, and within a few years investors had bid up Internet-related stocks, creating a speculative bubble.

In the 1970s, markets expanded to provide
a range of risk management tools (currency futures, bond futures, and stock
options, to name a few) that permitted managers to move significantly away
from long only based portfolio analysis. In the 1980s, stock index futures
and index options were developed. New forms of dynamic risk management, such as portfolio insurance, also came into existence. In the 1990s,
new asset sectors such as mortgages, new approaches to asset management
such as hedge funds, and a wider range of investment vehicles such as
Collateralized Debt Obligations (CDOs) were developed. By 2000, financial
engineers had come into their own, developing even more complex invest-
xiv
PREFACE
ment instruments and vehicles, each designed to further cauterize and trade
market risk. Unfortunately, few investors considered that each of these new
investment forms or vehicles fundamentally changed the relationship
between assets and how those assets would perform and respond in extreme
economic environments.

…

To go beyond that point is to either enter the world of the absurd or court
unintended consequences without preparation. In Chapter 3, we speak to
this point as we examine certain theories that provide very real value within
their parameters, but have been misused or are not allowed to die a proper
death because they serve an unintended and sometimes misguided purpose.
We have also seen this phenomenon at work in the current market. The
Collateralized Debt Obligation (CDOs) is first and foremost an asset allocation product and was first designed by JP Morgan to assist its clients in
securitizing certain obligations. In designing this program, the bank also
designed risk control features that assured a workable understanding of the
bank’s obligations as well as those of its clients. We have witnessed the
awful destruction of wealth tied to this asset allocation product when discretion and proper risk controls are removed from its design.

Mortgage-backed securities were already safe investments, but could that safety be maintained while enhancing returns? If you could figure this out, you could make a lot of money.
This was achieved by the technique of “tranching the security,” which turned the simple mortgage-backed securities (the bucket of mortgage payments sold onto investors described earlier) into a contract called a “collateralized debt obligation” (CDO).15 The technique combined the mortgage payments of many different bits of real estate, from many different places, in the same security, but it kept them separate by selling different parts of the security to different people via different “tranches” (or tiers). Basically, you take a bit of the east side of Manhattan and blend that with a bit of Arizona suburb and a bit of Baltimore waterfront, and you pay the holders of the different tranches (usually called senior, mezzanine, or equity tranches) different interest rates according to how risky a tranche they bought.

Perhaps the most colorful articulation of this accusation came from Rolling Stone’s Matt Taibbi in his July 2009 takedown of Goldman Sachs that famously labeled the Wall Street firm “a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”54
Economists who have studied financialization have found a strong correlation between the growth of the financial sector and inequality as well as the decline in labor’s share of national income.55 Since the financial sector is, in effect, imposing a kind of tax on the rest of the economy and then reallocating the proceeds to the top of the income distribution, it’s reasonable to conclude that it has played a role in a number of the trends we’ve looked at. Still, it seems hard to make a strong case for financialization as the primary cause of, say, polarization and the elimination of routine jobs.
It’s also important to realize that growth in the financial sector has been highly dependent on advancing information technology. Virtually all of the financial innovations that have arisen in recent decades—including, for example, collateralized debt obligations (CDOs) and exotic financial derivatives—would not have been possible without access to powerful computers. Likewise, automated trading algorithms are now responsible for nearly two-thirds of stock market trades, and Wall Street firms have built huge computing centers in close physical proximity to exchanges in order to gain trading advantages measured in tiny fractions of a second. Between 2005 and 2012, the average time to execute a trade dropped from about 10 seconds to just 0.0008 seconds,56 and robotic, high-speed trading was heavily implicated in the May 2010 “flash crash” in which the Dow Jones Industrial Average plunged nearly a thousand points and then recovered for a net gain, all within the space of just a few minutes.

Coming back to modeling credit risk, if the credit derivative is about a basket of several underlyings, the degree of co-dependence, that is, a broader measure than the traditional correlation coefficient based on a linear regression, will significantly affect the credit risk premium. Indeed, the aim is to price a multivariate product (the default probability of each of the basket constituents) in a consistent way with the prices (over time) of several univariate products.
Application to the Pricing of a CDO7
Basket CDSs (cf. Section 12.1.5) are also embedded into “synthetic securitizations”, often called collaterized debt obligations (CDO), for example the C*Star 1, 1999–2001 of Citibank (data 1999), shown in Figure 13.6.
Figure 13.6 Example of a CDO
In this example, the CDO involves the lower CDS in the figure, in bold (the upper one is a regular CDS with a bank). This second CDS transfers the credit risk to an entity (C*Star) called a special purpose vehicle (SPV), whose function is to pool the debts into several notes, called tranches, offered to investors.

pages: 293words: 88,490

The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction
by
Richard Bookstaber

Treasury secretary Henry Paulson, assuring a House Appropriations subcommittee that “from the standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be contained.”
Less than three months later, this containment ruptured when two Bear Stearns hedge funds that had held a portfolio of more than twenty billion dollars, most of it in securities backed by subprime mortgages, failed, marking a course that blew through one financial market after another over the following six months—the broader mortgage markets, including collateralized debt obligations and credit default swaps; money markets, including the short-term financing of the repo (repurchase agreement) and interbank markets; and markets that seemed to be clever little wrinkles but turned out to have serious vulnerabilities, such as asset-backed commercial paper and auction-rate securities.
In early 2008, as the market turmoil raged, Bernanke gave his semiannual testimony before the Senate Banking Committee.

…

In war, the key to victory is creating both complexity through the confusion sown by quick changes and the tight coupling that prevents successful adjustments to those changes. The objective is to move to unanticipated new environments, thereby creating endogenous uncertainty. In finance, we have seen this through the arms race of leapfrogging others in trading speed in high-frequency trading, and in adding the fog of complexity to the environment through derivatives. In the 2008 meltdown, that complexity could arrive in the form of things like synthetic collateralized debt obligations—derivatives based on derivatives.
If we are going to use the analogy of war in economics and finance, the battlefield where Boyd’s dictum most applies is the realm of information. One tactic in this battlefield is to create informational asymmetries. If the market is becoming efficient, if information is immediately accessible to everyone at the same time, then either create new private information or else speed up your access to the public information.

…

To see this, look at the structured financial products coming out of a trading desk in the way petroleum products come out of the distillation tower in a refinery. There, crude oil comes in, and is separated or “cracked” into various grades of products, from heavy heating oil to light naphtha. The raw material for the structured products at the heart of the 2008 crisis was mortgage-backed securities (MBSs), and the distilled products are various grades or tranches of collateralized debt obligations (CDOs), where the grade is determined by the risk of default. Just as any product coming out of the distillation process depends on the crude oil that feeds the process, any CDO coming out of the securitization process will have the markings of the MBS that comprises the feedstock. If the feedstock is tainted or diluted, the structured products will be as well. If the feedstock includes subprime mortgages that rise in defaults, any security that comes out of the process, or that uses those products as its own raw material, will be affected.

The stock would end the day up $14.74, or 46.4 percent to $46.49, for the biggest
one-day gain in the stock since it went public in 1994. William Tanona, an analyst with Goldman
Sachs, raised his rating on Lehman to “buy” from “neutral.”
When the session ended, the excitement at Lehman was palpable. Gregory rushed over to give
Callan a big hug. Later, as she went down to the bond-trading floor, she passed by the desk of
Peter Hornick, the firm’s head of collateralized debt obligation sales and trading. He held out his
palm, and she slapped him a high-five.
For a brief, shining moment, all seemed well at Lehman Brothers.
019
Outside Lehman, however, skeptics were already voicing their concerns. “I still don’t believe any
of these numbers because I still don’t think there is proper accounting for the liabilities they have
on their books,” Peter Schiff, president and chief global strategist of Euro Pacific Capital, told the
Washington Post.

…

But that analysis did not take into account a number of other critical factors, such as the fact that
the link between the housing market and the financial system was further complicated by the
growing use of exotic derivatives. Securities whose income and value came from a pool of
residential mortgages were being amalgamated, sliced up, and reconfigured again, and soon
became the underpinnings of new investment products marketed as collateralized debt obligations
(CDOs).
The way that firms like a JP Morgan or a Lehman Brothers now operated bore little resemblance
to the way banks had traditionally done business. No longer would a bank simply make a loan and
keep it on its books. Now lending was about origination—establishing the first link in a chain of
securitization that spread risk of the loan among dozens if not hundreds and thousands of parties.

…

She used the word
‘incredibly’ eight times,” he noted.
“I would use ‘incredible’ in a different way to describe the report.”
After that rhetorical flourish, he recounted how he had decided to call her. With a projection
screen displaying the relevant figures behind him, he told how he had questioned Callan about the
fact that Lehman had taken only a $200 million write-down on $6.5 billion worth of the especially
toxic asset known as collateralized debt obligations in the first quarter—even though the pool of
CDOs included $1.6 billion of instruments that were below investment grade.
“Ms. Callan said she understood my point and would have to get back to me,” Einhorn relayed.
“In a follow-up e-mail, Ms. Callan declined to provide an explanation for the modest write-down
and instead stated that, based on current price action, Lehman ‘would expect to recognize further
losses’ in the second quarter.

As to the division of junior from senior debt, Paulson had never seen anything quite like the feast that the mortgage industry served up. Lenders like Daniel Sadek generated mortgages that were sold to Wall Street banks; the banks turned these into mortgage bonds; then other banks bought the bonds, rebundled them, and sliced the resulting “collateralized debt obligation” into layers, the most senior ones rated a rock-solid AAA, the next ones rated AA, and so on down the line to BBB and lower—there might be eighteen tranches in the pyramid. If the mortgages in the collateralized debt obligation paid back 95 percent or more of what they owed, the BBB bonds would be fine, since the first 5 percent of the losses would be absorbed by even more junior tranches. But once non-payments surpassed the 5 percent hurdle, the BBB securities would start suffering losses; and since the BBB tranche was only 1 percent thick, a nonpayment rate of 6 percent would take the whole lot of them to zero.

…

This contrast points to a third reason why the banks fared poorly in the credit bubble: Those multiple profit centers distracted executives. The banks’ proprietary trading desks coexisted alongside departments that advised on mergers, underwrote securities, and managed clients’ funds; sometimes the scramble for fees from these advisory businesses blurred the banks’ investment choices. Again, the subprime story illustrated this problem. Merrill Lynch is said to have sold $70 billion worth of subprime collateralized debt obligations, or CDOs, earning a fee of 1.25 percent each time, or $875 million. Merrill’s bosses obsessed about their standing in the mortgage league tables: The chief executive, Stan O’Neal, was prepared to finance home lenders at no profit in order to be first in line to buy their mortgages.14 To feed their CDO production lines, Merrill and its rivals kept plenty of mortgage bonds on hand; so when demand for CDOs collapsed in early 2007, the banks were stuck with billions of unsold inventory that they had to take onto their balance sheets.

…

But in the summer of 2007, Griffin found his vacation impossible to enjoy. Every day began with phone calls back to Chicago and ended the same way, and by Friday morning, Griffin had had enough. “Don’t take this the wrong way,” he told his wife. “You can come or you can stay. I’m going.”19
That Friday, July 27, was the day when the subprime troubles morphed into a larger credit crisis. Loans from guys who catapulted Porsches, byzantine collateralized debt obligations with eighteen layers, the whole pyramid of side bets on the ABX index—until just recently, all could be dismissed as a mania confined to one corner of the markets. But that Friday a Boston-based hedge fund named Sowood Capital Management began to catch fire. Its $3 billion portfolio was down sharply, and it was starting to receive margin calls from brokers.20
The remarkable thing about this development was that Sowood had avoided subprime securities.

Marieke de Goede, for example, characterizes money as “a system of writing that is firmly rooted in cultural history” (Goede 2005: xxv).
39 The prospect of a “comparison between the images of saints in different religions and the bank notes of different states” intrigued him, for example.
40 Agamben refers to the mark on a coin as a signature which “transforms a piece of metal into a coin, producing it as money” (Agamben 2009: 40).
41 Material monies—digital monies present a distinctive set of problems, as the recent history of Bitcoin testifies—need to be “read” quickly, validated by a glance. But the technology needed to make such a reading infallible (raised print, watermarks, holograms) is increasingly costly and complex, and difficult to read by sight alone. Finance is read differently, with its history of charts and graphs (Preda 2009), although it may have caught up with money in some respects. Credit ratings, too, are instantly legible, although those attached to collateralized debt obligations turned out to be tainted and their very legibility became a source of contagion (Carruthers 2010). Even here, a narrative is attached to the rating, which is unraveled whenever the rating shifts, or when various ratings agencies offer different grades for a particular financial product.
42 Bretton Woods refers to the international monetary system that was established in 1944, wherein countries agreed to adopt monetary policies aimed to ensure that their currencies maintained fixed rates of exchange against the U.S. dollar, which was in turn “pegged” to gold.

…

For Harvey, capital’s centralization through the credit system is integral to this idea because a credit crisis (the devaluation of capital) invariably leads to the destruction of money (inflation) (Harvey 2006: 328). In these terms, the policy whereby governments (via central banks) seek to stimulate effective demand by keeping interest rates low (or, recently, through quantitative easing) amounts to replacing privately created fictitious capital (such as collateralized debt obligations) with state-backed capital (or money). This additional money can be reinvested in production (leading to wage increases), channeled into speculative finance (leading to the creation of even more fictitious capital), or pumped into consumption (creating further upward pressure on wages). Either way, a crisis may be eased but cannot be averted; indeed, its symptoms are likely to be worse.

…

Token money was developed as a solution to this problem, bridging the time gap in the circulation of commodities and making up the shortfall whenever money as a medium of circulation is in short supply. Credit money, as we have seen, “springs” from this. But for Marx, credit money is not money; or rather, it answers only one requirement of money. Hence the proliferation of monies in modern capitalism—commodities, paper, coins, and various forms of credit, derivatives, collateralized debt obligations, and so on—has been driven by the attempt to reconcile the desire for a quality store of value with the requirement for a frictionless medium of exchange. Periodically, fixity inevitably comes into conflict with flow.
There are two important points to be taken out of this discussion of Marx’s theory of money and credit. The first point concerns the connection between money and the real economy.

Other studies show that correlation risk is priced in the cross-section of equity returns (stocks with higher sensitivity to rising correlation need to offer higher long-run returns) and in time series (the aggregate market has higher returns following higher average correlations).
There is a large literature that goes beyond equities and focuses on implied default correlations based on collateralized debt obligation (CDO) tranche prices in liquid credit default swap (CDS) indices. The manufacturing of CDOs involves two steps: first, many securities are pooled into a diversified portfolio (special purpose vehicle or SPV), then the resulting cash flows are redistributed to tranches of varying seniority within the CDO. Tranches are typically assigned credit ratings from AAA to BBB, except for the unrated, most junior (equity) tranche, which takes the first default losses; higher yield spreads compensate lower seniorities.

Pretty cool, think of all the industries from Silicon Valley to biotech to mutual funds that grew like weeds once money flowed out of rocks into rolls. Entrepreneurs flourished. Dow 1000 to Dow 14000 meant amazing wealth creation - Gates, Buffet, Dell but also rippling though 401K plans and home values.
So how bizarre is it that the end of the bull run came not from inflation returning, or so it seems, but from an overextension of asset backed financial instruments. The ‘70’s dressed up as a Collateralized Debt Obligation. I half expect bell bottoms to make a comeback.
Wealth needs to be rebuilt. But the Federal Reserve can’t just print it. That will inevitably increase prices and inflation and a return to the ugly ‘70’s.
It has to be earned. Profits. Human profits. Company profits. Fortunately, we have structure the economy for just such a task. The stock market hasn’t gone away, it still works as a way to efficiently allocate capital.

As Mauldin says of the old—and still dominant—order on Wall Street: “Let’s be very clear.71 This was purely gambling. No money was invested in mortgages or any productive enterprise. This was one group betting against another, and a lot of these deals were done all over New York and London.”
Mauldin goes on to question why large institutional investors were even gambling on such things as synthetic collateralized debt obligations in the first place: “This is an investment that had no productive capital at work and no remotely socially redeeming value.72 It did not go to fund mortgages or buy capital equipment or build malls or office buildings.”
Commenting on our looming debt crisis, Princeton economist Alan Blinder noted that “in 1980 [policymakers] knew about the year 2010 but that was really far away.”73 Well, it’s not anymore, and given that much of our deficit problem is about huge numbers of workers born decades ago now hitting retirement age, Blinder quipped, “The long run is now the short run and they’re combining.”

…

We’ve just seen the way middle-class incomes had fallen behind expenses over the past three decades. How is it that more and more Americans were able to buy more and more houses—even as incomes stagnated? By taking on more debt, of course, provided by an underregulated army of lenders pitching seductive new mortgage vehicles. By 2005, subprime mortgages had skyrocketed to 20 percent of the market.63
Fueling the boom was the development of securitized mortgages—including collateralized debt obligations (CDOs)—in which mortgages of varying degrees of risk were bundled together in “tranches” and sold to investors.64 Since lenders were selling off the risk to someone else, they felt much freer to make loans to borrowers who never would have been able to qualify for a prime mortgage.
The Fed did its part, too, contributing extremely low interest rates and lax oversight to the increasingly toxic housing mix.

For example, when you hear the words ‘‘toxic assets’’ or ‘‘troubled
assets’’ on the evening news, most of what you are hearing about are
structured finance instruments based on pools of mortgages,
Financial Innovation Made Easy
‘‘collateralized mortgage obligations’’ or CMOs. These proved such a
success in getting mortgages off the books of lenders that the same
structuring process was used to get business loans off the books.
These collateralized loan obligations, or CLOs, were joined by collateralized debt obligations, or CDOs, that pooled corporate debt. Obviously, such instruments lose value very quickly when the value of the
underlying mortgages, loans, and bonds becomes questionable. Basically, they become ‘‘unsaleable.’’ Buying and selling makes prices, so
without such transactions, there is no way to put a value on these
instruments.
DERIVATIVES PILED ON DERIVATIVES
All this would be bad enough, but it gets worse.

Leverage increases risk, but it also increases expected return, and it is not irrational to accept that tradeoff within limits that in the latest bubbles were not thought to have been exceeded, because of the new financial instruments that were believed to minimize risk. Indeed they, along with the magical combination of low interest rates with low inflation, were the key innovations that made the era seem new, along with one I haven't mentioned yet—the special investment vehicle. A bank that created a risky asset, say some form of collateralized debt obligation (a more complicated version of a mortgage-backed security), might place it in a separate entity, created to hold the asset, rather than keeping it on its books, so that if the asset crashed the bank's capital would not be impaired. As long as the bank disclosed in advance that it was not guaranteeing any losses sustained by the entity, investors could not complain; they would be taking a risk with their eves wide open.

…

But I have acknowledged that there are political problems with pricking asset-price bubbles, and the Federal Reserve cannot maintain its political independence if it ruffles too many political feathers.
Not enough economists noticed (or at least remarked) the relation between executive compensation practices and risky lending, or appreciated the riskiness of mortgage-backed securities, other collateralized-debt obligations, and credit-default swaps, or connected the decline in personal savings to the danger that such lending posed to the economy. Not enough seem to have realized that the crisis of the banking industry, when it hit, was a crisis not of (or at least not mainly of) illiquidiry but of insolvency. Not only were warning signs ignored until too late, but when the economics profession finally woke up we learned that neither government economists like Bernanke nor private economists had prepared any contingency plans for dealing with a depression.

A few bettors had already been badly burned, spending too much on premiums and eventually pulling out of the game, frustrated and bitter that the housing market hadn’t yet imploded. Paulson too had been betting on a housing collapse, but he’d assembled a big enough war chest from his wealthy hedge fund clients to keep playing, despite the continued buoyancy of the housing market. After the meeting with Shilling, he was convinced that now was the time to go really big.
One frustration for Paulson was that there just weren’t enough of these stocks, known as collateral debt obligations (CDO), to bet against. So he decided to become proactive. He approached a number of investment banks with the request that they create more CDOs to sell to clients, so that he could then take out ‘insurance’ betting that these would fail. The arrangement Paulson had in mind was rife with potential conflicts of interest. He clearly wanted to help pick the mortgages that would make up the new CDOs.

…

In the age of winner-take-all compensation, a similar propensity for cheating seems to have infected the upper levels of the business and financial worlds. It’s worth considering whether the mindset that led Wall Street types to abandon all sanity and morality – mixing together toxic brews of junk mortgages, car loans and credit card debts and then selling pieces of these sickly concoctions to unknowing ‘investors’ – is partly the result of the overstimulation of their greed impulses.
When the broader public first became aware of collateral debt obligations and credit default swaps during the financial meltdown in the autumn of 2008, the most common reaction was bewilderment. The hypercharged Wall Street world was so removed from the regular world most people inhabit – where pay bears some relationship to hours worked, effort and results – that it seemed baffling and indecipherable. How did grown men and women make decisions that were not just over-the-top greedy but were so evidently irresponsible and threatening to the well-being of so many others, including themselves?

In 1997, the Asian century was still-
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born. In 1998, Russia defaulted. In 2001, Argentina completed its transition from first world to third world economy under the weight of debts
that the country would never be able to service, let alone repay.
Credit derivative products emerged. Credit default swaps and collateralized debt obligations (CDOs) allowed investors to take on credit risk. On
schedule, in 2001, the CDO market collapsed, leaving the investors to
nurse sizeable losses. In between, there were dalliances with gold, weather
and catastrophe bonds that kept the markets busy.
Forbidden fruit
Back at the training programme, I generally finished my class for trainees by
taking them through a structured product – an inverse floater, which I used
to illustrate structured products.

…

Regulations required insurance companies holding junk bonds to provide a
lot of reserves against the investment. To get around the rules, insurance
companies repackaged the high yield assets into CBOs and transferred the
riskier parts to their holding companies (which did not have to hold
reserves). Now, CBOs in a more modern form were used to repackage
credit risk for investors. It was even given a new name – CDO
(Collateralized Debt Obligations).
Imitation and flattery
In the 1970s, mortgage securitization developed in the US. Banks originally had written mortgage loans, then they had waited 30 years for the
homeowners to pay it back. Now, banks wrote the loan and once they had a
bunch they sold them to a special purpose vehicle (SPV). The SPV paid the
bank for the mortgages it bought. It issued bonds in the market to raise the
cash.

The most important innovation was, arguably, in the allegedly mathematically rigorous pricing of derivatives – financial assets that ‘derive’ their value from the prices of underlying assets, such as stocks or bonds, indices, or interest rates.30 But, it should be noted, Nassim Nicholas Taleb, famous for the ‘Black Swan’ (an unforecastable event), views the theories underlying the pricing of derivatives as intellectually fraudulent.31 But, aided by rising computing power, this almost universally accepted intellectual innovation led to an explosion in the invention and trading of ever more sophisticated products, including the infamous collateralized debt obligations (CDOs), synthetic collateralized debt obligations and CDOs squared, which triggered the global financial crisis of 2007–08. (These instruments are explained further below.) According to the Bank for International Settlements, between June 1998 and June 2008 the notional value of outstanding over-the-counter derivatives exploded from $72tn to $673tn (whereupon it stagnated), the latter being just under eleven times global gross product.

…

This was true in the US and the UK, but also in Iceland, Ireland, Spain, and parts of Central and Eastern Europe. It was true of households and companies, particularly investors in property, property developers and those engaged in leveraged buy-outs. With more debt relative to equity, and overvalued asset prices, the outcome was extreme vulnerability to crisis.
In addition, the market-based financial system embedded an enormous amount of leverage inside financial instruments. Collateralized debt obligations (CDOs) are an excellent example, with leverage inherent in the process of tranching cash inflows. Synthetic CDOs, which are created by pooling and tranching credit-default swaps on asset-backed securities and other bonds, involve much the same process. Think of the simplest possible CDO, one in which the underlying interest payments and mortgage repayments are divided into just two securities: the lower risk of these two securities would be entitled to receive the first 50 per cent of all the payments and repayments; the higher risk of these securities would get the rest.

Other bankers were also eager to satisfy the demand of their clients for higher-yielding assets in a world where US Treasuries were paying only 2 per cent for ten-year bonds. In the 2008 edition of his book The Return of Depression Economics, Paul Krugman noted the ‘complete abandonment of traditional principles’ of lending.7 It is true that some individual families were motivated by dreams of owning their own spacious home, but the explosion of credit was as much driven by the suppliers of credit who created such novel instruments as Collateralized Debt Obligations, or CDOs for short, to satisfy the need for higher yields.
This so-called ‘securitization’ of assets has been described as the act of ‘turning an expected future cash flow into tradable bond-like securities’.8 A famous example of securitization occurred when Bowie Bonds were created in 1997. The original bond sold that year raised $55 million for the rock musician David Bowie. Future album sales of his music generated the revenue stream for the securities.

…

From June 2006 to September 2007, the rate was held at 5.25 per cent, having risen from a low of 1 per cent in June 2003.15 This increase, between 2003 and 2006, would eventually put pressure on mortgage holders. Yet by late August 2007 it was already too late to supply relief. At that time, funds and banks around the world had already ‘taken hits’ because they had purchased bonds backed by US home loans, ‘often bundled into financial instruments called collateralized debt obligations, or CDOs’. An Australia-based professor of finance observed that it was ‘amazing how much ignorance and fear are out there’.16 In the spring of 2008, the former ‘maestro’, Alan Greenspan himself, writing in a blog on the Financial Times’s website, referred in his jargon-filled academic prose-style to the ‘dramatic fall in real long-term interest rates’ which ‘statistically explains, and is the most likely major cause of, real estate capitalization rates that declined and converged across the globe’.

Earlier theories, Dekker argues, have been tripped up by their tendency to explain instances of failure in complex environments by blaming flawed components rather than the workings of the organizational system as a whole.2 Dekker concludes, by contrast, that failure emerges opportunistically, nonrandomly, from the very webs of relationships that breed success and that are supposed to protect organizations from disaster. Dekker also observes that systems tend to drift in the direction of failure, gradually reducing the safety margin and taking on more risk, because of pressures to optimize the system in order to be more efficient and competitive.
We are able to build complex things—deep-sea oil rigs, spaceships, collateralized debt obligations—all of whose properties we can understand in isolation. But with complex systems in competitive, regulated societies—like most organizations—failure is often primarily due to unanticipated interactions and interdependencies of components and factors or forces outside the system, rather than failure of the components themselves. The interactions are unanticipated, and the signals are missed.

FINRA says Goldman did not have the proper procedures in place to make sure that this disclosure was made (R).
2011: In March, former Goldman board member Rajat Gupta is charged by the SEC with insider trading for passing information to the hedge fund Galleon Group that he learned in his capacity as a board member. Six months later he is arrested on criminal charges, soon after the SEC charges another Goldman employee with insider trading. In April, Senator Carl Levin (D.-Mich.) releases the 650-page report of the Senate investigation into the credit crisis (R). It concludes that Goldman misled clients and Congress about the collateralized debt obligations that helped cause the financial crisis. The report urges regulators to identify any violations of law in the activities of Goldman leading up to the financial crisis. The report asserts that conflicts of interest led Goldman to place its financial interests before those of its clients. The report is the result of a two-year probe by the Permanent Subcommittee on Investigations. In May, the report is referred to the Department of Justice and the SEC.

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Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America
by
Danielle Dimartino Booth

I imagined my fellow Wall Streeters going to the cathedral in my neighborhood and lighting candles. Thanks be to God and Greenspan.
In August 2000, my firm, DLJ, was purchased by Credit Suisse for $11.5 billion. By January 2001, when we were all called in for that companywide meeting, the Swiss company’s stodgier, more regimented culture had already collided with DLJ’s entrepreneurial spirit.
The bankers began describing their new product: a $340 million collateralized debt obligation (CDO), essentially a bond composed of home mortgages sliced into various tranches that produced income streams. Each tranche had been rated by Moody’s, Standard & Poor’s, and Fitch Ratings, the three most important ratings agencies. The AAA rating stood at the top, then AA, and so on down the ratings ladder until the bottom, the “equity” tranche.
The highest-rated tranches paid out first, as much as 10 percent, significantly higher than the average yield on a corporate bond with the same rating; the last to pay out was equity.

To turbocharge the market for credit derivatives, the J.P. Morgan team eventually created a product called a broad index secured trust offering (BISTRO). Complex in its details and accounting, the product was nevertheless simple in essence—it aggregated the odds of default on a whole package of loans, not just on a single credit. Collateralized debt packages had long been around, but BISTRO represented a whole new segment—synthetic collateralized debt obligations (CDOs). Wall Street has an endless ability to slice and dice, though; and as soon as it was created, BISTRO was separated into various “tranches” that carried different levels of risk and return. Investors in the junior tranche would eat the first losses due to any defaults, and therefore earn the highest return. The mezzanine tranche came next, and after that was the senior tranche.

…

Her response: “So why is everyone so surprised?” (Dimon is fond of Mark Twain’s wry comment that history does not repeat itself, but it does rhyme.)
One answer to Laura Dimon’s question is that this time around it wasn’t just one entity (such as Long-Term Capital Management) or one investment product (such as Internet stocks) that melted down. Almost every credit product out there collapsed—subprime mortgages, mortgage-related collateralized debt obligations, asset-backed commercial paper, auction-rate securities, SIVs, Alt-A mortgages, financial insurers, home equity.
Among the large commercial and investment banks, only Goldman Sachs and JPMorgan Chase seem to have been in any way prepared for the possibility of disaster. In March 2007, Dimon had written in the company’s 2006 annual report, “Credit losses, both consumer and wholesale, have been extremely low, perhaps among the best we’ll see in our lifetimes.

Mirroring Anthony Trollope’s 1867 novel Last Chronicle of Barset, whose characters invest in mortgages, investors purchased MBSs as low risk and secure investments paying regular income. The higher return available on securitized bonds relative to ordinary securities of similar quality was attractive.
Synthetic Stuff
In the 1990s, securitization underwent a makeover, being rebranded CDOs (collateralized debt obligations), a term subsuming various types of underlying loans and securitization formats. In 1997 JP Morgan introduced synthetic securitization, overcoming the unwieldy need to transfer the underlying loans to the SPV and also lowering the cost of transferring the risk. Instead of selling the loans, the lender now purchased credit insurance against the risk of loss using a credit default swap (CDS).

…

In practice, risk was spreading like a virulent virus through the financial system, ending up in unknown places in the hands of investors, who did not understand the complex risks that they assumed. As Iceland imploded during the financial crisis, traders speculated that the Icelandic banks’ fatal dalliance with structured finance was simply confusion between the word c-o-d (an area of Icelandic expertise) and the non-piscine c-d-o (collateralized debt obligations).
Get Copula-ed
Assorted statisticians, mathematicians, scientists, and MBAs with little knowledge of banking now shaped packages of loans into complicated objets d’art. They built simplified models to predict patterns of cash flows from the underlying loans. In the ultra-rational world of efficient markets, prepayments were assumed to be linked to interest rates adjusted for behavioral nuances.

There was no historical precedent for such low-quality mortgages. It is easy to see how the BBB tranche of a bond formed from these low-quality
mortgages would be extremely vulnerable to a complete loss.
The story, however, does not end there. The BBB tranches were difficult to sell. Wall Street alchemists came up with a solution that magically
transformed the BBB tranches into AAA. They created a new securitization called a collateralized debt obligation (CDO) that consisted entirely of
the BBB tranches of many mortgage bonds.7 CDOs also employed a tranche structure. Typically 75 percent to 80 percent of a CDO was rated
AAA, even though it consisted of 100 percent BBB tranches.
Although the CDO tranche structure was similar to that employed by subprime mortgage bonds consisting of individual mortgages, there was an
important difference.

…

How did you get involved in trading the subprime mortgage market?
I first became aware of the opportunity in October 2006 when a friend sent us a write-up of a presentation made by Paul Singer of Elliot
Associates. Singer walked through the sleight-of-hand that banks used to amalgamate the riskiest tranches of subprime mortgage-backed
securitizations (MBS)—the BBB tranches that investors were starting to shy away from—into a new collateralized debt obligation (CDO), the
majority of which was rated AA or higher. 9 Singer demonstrated that housing prices didn’t have to fall for the AA tranches of these CDOs to
fail; they simply had to stop rising. The assertion that institutional investors were willing to accept the paltry returns associated with AA or
higher rated securities for that kind of risk didn’t even seem plausible. If it hadn’t been someone with Singer’s reputation making these
assertions, I would never have believed him.

…

Planet Money is a highly creative, entertaining, and
insightful financial program. I have listened to every podcast since the program’s inception, and I highly recommend it.
4If this comment is unintelligible to you, don’t worry. A primer on mortgage-backed securities and their role in the financial crises is provided
later in this chapter before our conversation related to Cornwall’s short trade in collaterized debt obligations (CDOs).
5Mai explained that the typical quoting convention for implied volatility in interest rate markets, known as “normalized volatility,” is the number of
absolute basis points reflecting a one-standard-deviation event, as opposed to the standard convention of quoting implied volatility in other
asset classes in terms of percentage changes in the underlying security. Normalized volatility of 100 basis points equals a much smaller
volatility, as measured in “traditional” percentage terms, when rates are high than when they are low—a characteristic that may have been an
additional factor amplifying the anomaly.
6The expected value is the sum of the probability of each outcome multiplied by its value.

Eerily echoing the reviled Gordon
Gekko of Oliver Stone’s morality tale Wall Street, Ray Diallo, founder of
hedge fund Bridgewater Associates, noted, “The money that’s made from
manufacturing stuff is a pittance in comparison to the amount of money
made from shuffling money around.” 2007 was the year many first learned
124
Carjacked
the terms “predatory lending” and “hedge fund,” both of which have come
to hit American car owners, not just home owners, with a vengeance.
The housing crisis grabbed the headlines beginning in 2007, but auto
loans played a meaningful role in the CDO market that helped precipitate
the crisis. CDOs are collateralized debt obligations, also known as credit
derivatives, a financial instrument dating back to the early 1990s that is essentially the securitization of risk. When an investor, such as a bank or
hedge fund, purchases a credit derivative, he is buying not a bundle of
home or auto loans but a portion or all of the risk of that bundle. As the
housing market exploded and Americans bought more and bigger vehicles
in the early years of the new century, the CDO market blossomed, and
some people got quite rich essentially taking Vegas-style bets on whether
ordinary people would get to keep or lose their homes or cars.

By turning a blind eye to the recklessness, Brussels had constructed a no-lose situation. If the euro succeeded they won praise and if the euro came under stress they won power. The stress came soon enough.
The European banks gorged not only on euro sovereign debt but also on debt issued by Fannie Mae and the full alphabet soup of fraudulent Wall Street structured products such as collateralized debt obligations, or CDOs. These debts were originated by inexperienced local bankers around the United States and repackaged in the billions of dollars by the likes of Lehman Brothers before they went bust. The European banks were the true weak links in the global financial system, weaker even than Citigroup, Goldman Sachs and the other bailed-out icons of American finance.
By 2010, European sovereign finance was a complex web composed of cross-holdings of debt.

About a month later, on February 27, Citigroup announced the U.S. government would be taking a 36 percent equity stake in the company by converting $25 billion in emergency aid into common shares. Citigroup shares dropped 40 percent on the news. In aggregate the aid provided to the bank totaled $45 billion.
Because banks are highly leveraged, it is crucial to thoroughly analyze their assets, as a small percentage loss can quickly wipe out the equity. During the financial boom, Citigroup made many speculative investments, particularly in collateralized debt obligations (CDOs), mortgages, derivatives and other types of structured products. When the value of these assets deteriorated, they took enormous write downs, which in turn required them to raise more equity. Investors lined up to purchase equity in Citigroup starting in October 2007 as they thought the decline in the stock price represented a good buying opportunity.
However, as the losses mounted and the write-downs increased, the stock price collapsed.

…

Michael Neumann, a salesman on the Lehman Brothers credit desk, who had sold him CDS contracts on Farmer Mac, suggested that Ackman look at the bond insurers.
Ackman zeroed in on MBIA. It was the largest of the bond insurers, the largest guarantor of municipal bonds in the United States. While MBIA had its origins insuring low-risk municipal bonds, in more recent years it had begun to move into the more lucrative business of insuring exotic and highly risky collateralized debt obligations (CDOs) and other structured products. Ackman believed that the company was underreserved relative to the risk it was underwriting, was overleveraged, and was engaging in various accounting devices to shield losses and accelerate gains. He believed that it was poised for a dramatic fall. Ultimately, Ackman concluded that the business, despite its triple-A rating, was likely insolvent.

Long-term actuarial approach versus the market approach to credit. Goldman Sachs sees opportunity in default swaps. The market approach vindicated by Enron’s bankruptcy.
TWO Going to the Mattresses
The advent of VAR and OTC derivatives. The collapse of Long-Term Capital Management (LTCM). A fatal flaw is exposed. The wrong lesson is learned.
THREE A Free Lunch . . . with Processed Food
A new market for collaterized debt obligations (CDOs). Risky investments, diversification, and the role of the ratings agencies. Barclays finds investors for its CDOs, only to fall out with them.
FOUR The Broken Heart Syndrome
J.P. Morgan and Deutsche Bank dominate the European CDO market. Innovation outpaces the ratings agencies. Traders make millions with the help of correlation models. Reasons for concern.
FIVE Regulatory Capture
The Fed lessens the restraints on big banks.

…

With these incentives in place, dry brushwood was in place that only needed two more things to catch fire: credit derivatives and securitization.
CHAPTER THREE
A Free Lunch . . . with Processed Food
A pioneering pack of very clever and ambitious traders—aided by some mathematical wizardry—figured out how to bundle risky investments into packages that carried triple-A ratings. This incredibly lucrative new market in collateralized debt obligations (CDOs), which was propped up by the ratings agencies, swept across Europe, as cautious banks sought new ways to diversify without taking on too much risk.
The Too-Perfect Investment
Like the grain of sand lodged in an oyster’s shell, an irritant sometimes drives what is—and should always be—an introspective, conservative company to outsize ambitions. This is what happened to Landesbank (LB) Kiel, along with its regional sibling, Hamburgische Landesbank, in which it had a 49 percent equity stake.

With money on all sides of every trade, it was hard for many players to tell at the end of the day whether they’d lost or won. At the end of 2007, the market for these swaps was estimated at $45.5 trillion—roughly twice as large as all U.S. stock markets combined.
The country’s financial markets had gone from being decontrolled to being uncontrollable. But as long as the market expanded, the profits seemed enormous and apparently insured against loss. The operating margins at the giant insurer AIG on collateralized debt obligation (CDO) insurance rose steadily; by 2002 the margin was 44 percent of revenue, and by 2005, 83 percent. The profits of the unit that sold CDOs rose from $737 million in 1999 to $3.26 billion in 2005. Fat bonuses, lavish parties, and padded expense accounts for exotic travel followed.
The credit boom built on subprime mortgages also provided real, if temporary, benefits to a large number of Americans who never bought a derivative.

The goal is to make the municipal bond insurer bankruptcy remote from losses that might occur on other insurance lines covered by the same holding company (i.e., with no possible contagion). In addition, the chartering laws have imposed relatively high capital requirements on the firms.
Quite irrationally, in recent years, insurance regulators have also allowed municipal bond insurers to provide coverage against default risks on subprime mortgage securitizations and related collateralized debt obligations (CDOs) and credit default swaps (CDSs). It is unclear why the insurance regulators allowed the insurers to mix the relatively limited credit risks on municipal bonds with the high risks on subprime mortgages and their derivatives, since this clearly violated the monoline principle on which the insurers were chartered.
Worse yet, losses on the subprime mortgage derivatives now threaten the solvency of the municipal bond insurers.9 The failure of these firms would have significant negative externalities in two regards.

But I didn’t write the book so that it wouldn’t get read. I’d been preaching its themes to whoever would listen at CIBC for years. It was time to take the message to a broader audience.
By the time I stepped away from the job, CIBC had much bigger things to worry about than my literary ambitions. At the time, the bank, like many financial institutions, was knee-deep in fancy financial market derivatives called collateralized debt obligations (CDOs). Prior to the housing market crash, CDOs, which are backed by assets such as homeowner subprime mortgages, were making investors a ton of money. They also seemed to be relatively safe investments, at least according to rating agencies that granted many of these debt instruments gold-plated Triple-A status. But when mortgage holders who took on too much debt stopped making payments, the market imploded in a hurry.

…

And since it often comes at the cost of endangering our own survival, there are other standards we should take into account. The surprising thing is that if we look at it through a different lens, the end of growth will leave us all richer than we ever may have thought.
[ SOURCE NOTES ]
INTRODUCTION
this page: A copious amount of ink has been spilled dissecting the US housing crisis and subsequent stock market crash in 2008. For a particularly lively account of the bubble that developed for collateralized debt obligations and the emergence of the credit default swap market, see The Big Short (2010) by Michael Lewis.
CHAPTER 1: CHANGING THE ECONOMIC SPEED LIMIT
this page: For a broader take on how Reaganomics fostered the culture of deregulation that still persists in the United States, see The Price of Civilization: Economics and Ethics After the Fall (2011) by Jeffrey Sachs, director of the Earth Institute at Colombia University.

They link the real economy with the financial economy.
Capital market participants – bankers, fund managers, private- equity investors and other ‘go-betweens’ – package their products in all sorts of ways, ranging from simple bank deposits and loans through to the ever-more complex instruments that make up the lexicon of international finance: syndicated loans, equities, corporate bonds, commercial paper, asset-backed securities, collateralized debt obligations and structured products. Ultimately, each of these products offers a claim on future economic wealth (or, put another way, a reward for abstinence today). Banks provide loans in exchange for an interest payment. Shareholders hold equities because they expect a dividend or a capital gain. Issuers of asset-backed securities provide a return in exchange for the apparent protection associated with the underlying asset.

…

The belief in the pot of gold refused to go away. Since equities couldn’t deliver the necessary returns, and government bond yields were ludicrously low, investors went in search of other assets that might do the trick. As with any other market, an increase in demand for high-returning non-equity assets was met with an increase in supply. Asset-backed securities, mortgage-backed securities, collateralized debt obligations and so on became the investments du jour. Banks packaged up vast quantities of loans into these securities and either tucked them away under the mattress as off-balance-sheet items in the form of conduits and special investment vehicles (SIVs) or, instead, sold them off to other investors – insurance companies, pension funds, hedge funds and, in some cases, local councils – who, collectively, became known as the ‘shadow banking system’.

The mortgage payments on the loans were used to pay the interest on the bonds. As defaults rose, the sub-prime lenders found it more difficult to get finance. Their business model was built on getting rid of the mortgages as quickly as they created them; in the absence of the cashflow from sales, they were unable to meet their debts.
The problem then rippled through the chain. The mortgage-backed securities had been bundled into other securities called ‘collateralized debt obligations’ (CDOs). These were designed to give investors a diversified pool of high-yield assets. Such assets were attractive as an ironic consequence of the great moderation; yields on cash and government bonds were low so investors were happy to chase higher returns.
These CDOs had been organized in tranches, like a kind of trifle. Each layer had different rights and expected returns. The so-called equity layer was the riskiest; it paid the highest yield but suffered the first losses when the bonds in the portfolio defaulted.

By the end of 2011 Treasury had received $15.45 billion of the $67.84 billion it put into AIG, and still owned 1.455 billion common shares of the company.6
Separately, in November 2008, the Fed created two investment vehicles to remove toxic assets from AIG’s balance sheets. The first, dubbed Maiden Lane II, borrowed $19.5 billion from the Fed and bought $20.8 billion in mortgage-backed securities at half of their original price. The second, Maiden Lane III, borrowed $24.3 billion from the Fed and bought a portfolio of collateralized debt obligations from former AIG customers, also at about half their face value. As the credit markets recovered, the investment vehicles—essentially hedge funds with concentrated positions—generated enough income to pay off the loans, and the Fed sold off chunks of the assets held by the Maiden Lane entities. The upshot? By the first quarter of 2012 Maiden Lane II had paid off the entire $19.5 billion loan, and Maiden Lane III was down to $8.9 billion in debt to the Fed, supported by assets worth $17.7 billion.

But in the wake of a number of financial crises, from the dot-com implosion of 2000 to the subprime mortgage crisis of 2008 and the financial meltdown that followed, we were rudely awakened to the reality that psychology and irrational behavior play a much larger role in the economy’s functioning than rational economists (and the rest of us) had been willing to admit.
It all started from questionable mortgage practices, augmented by collateralized debt obligations (CDOs are securities based mostly on mortgage payments). In turn, the CDO crisis accelerated the deflation of the housing market bubble, creating a reinforcing cycle of decreasing valuations. It also brought to light some questionable practices of various players in the financial services industry.
In March 2008, JP Morgan Chase acquired Bear Stearns at two dollars per share, the low valuation resulting from the fact that Bear Stearns was under investigation for CDO-related fraud.

S&P’s intrusion into American politics is also ironic because much of our current debt is directly or indirectly due to S&P’s failure (along with the failures of the two other major credit-rating agencies, Fitch and Moody’s) to do its job before the financial meltdown. Until the eve of the collapse, S&P gave triple-A ratings to some of the Street’s riskiest packages of mortgage-backed securities and collateralized debt obligations. Had S&P fulfilled its responsibility and warned investors of how much risk Wall Street was taking on, the housing and debt bubbles wouldn’t have become so large, and their bursts wouldn’t have brought down much of the economy. You and I and other taxpayers wouldn’t have had to bail out Wall Street; millions of Americans would have spent the subsequent years working instead of collecting unemployment insurance; the government wouldn’t have had to inject the economy with a massive stimulus to save millions of other jobs; and far more tax revenue would have been pouring into the Treasury from individuals and businesses.

David Fiderer, a former banker
turned journalist, calculates that from 2005 to 2007, roughly
$2.9 trillion of private-label ﬁrst-lien single-family mortgage
securities were issued, only about 15 percent of which were
purchased by Fannie and Freddie, and they bought the safest
possible part. That supposedly safer part of the securities—
the triple-A–rated ones—became increasingly easy to sell because so many buyers around the world were looking for “safe”
investments. As for the riskier pieces, it was a Wall Street
invention—the collateralized debt obligation—that became
the buyer. Without them, the last frenzied years of the bubble
wouldn’t have been possible.
The narrative that blames Fannie and Freddie and the
a≠ordable-housing goals ignores some other inconvenient
facts. Among them:
• The ﬁrst wave of subprime lenders in the 1990s grew up
outside the GSEs. The survivors from these companies became the dominant subprime lenders in the second wave,
a◊er 2000.

Banks under siege used to stack money in their windows to reassure depositors there was no need to run; when governments put enough “money in the window,” they can reduce the danger they’ll have to use it. The classic example is deposit insurance, Franklin Delano Roosevelt’s response to Depression-era bank runs. Since 1934, the government has guaranteed deposits at banks, so insured depositors who get worried that their bank has problems no longer have an incentive to yank out their money and make the problems worse.
Of course, the banking system that FDR inherited didn’t have “collateralized debt obligations,” “asset-backed commercial paper,” or other complexities of twenty-first-century finance. In the panic of 2008, insured bank deposits didn’t run on any significant scale, but all kinds of other frightened money did—and in the digital age, a run doesn’t require any physical running, just a phone call or a click of a mouse. By early 2009, the government had put a lot of money in the window through TARP and other emergency measures.

…

A WEEK later, the investment bank Merrill Lynch announced $7.9 billion in mortgage-related losses, the largest write-down in Wall Street history. That was almost twice as large a write-down as Merrill had predicted three weeks earlier, leaving the impression that losses were exploding and more unpleasant surprises lay ahead. Merrill CEO Stan O’Neal was forced out, although he did receive a $161.5 million severance to ease the blow.
The bulk of Merrill’s losses came from “collateralized debt obligations,” piles of mortgage-backed securities where the income streams had been sliced up and repackaged into smaller streams known as “tranches.” Merrill was a leading manufacturer of CDOs, and it had made billions selling them to investors around the world. But the investors, reaching for yield, had shown little interest in the safest tranches, the “super-senior” CDOs that would pay out in full unless mortgage losses were so severe that investors in every tranche below them were wiped out.

…

The measure is based on the implied volatility of options on the S&P 500 index of stocks. The VIX captures investor expectations of near-term stock market volatility—how uncertain investors are about whether and how far the S&P will rise or fall.
4 two complex new Maiden Lane vehicles: Among AIG’s major liquidity needs were their securities lending operations and the credit default swaps written by AIG Financial Products on collateralized debt obligations. Maiden Lane II and III addressed these issues, respectively, by purchasing the underlying collateral from AIG and its counterparties and canceling the CDS contracts that AIG owed against them. This eliminated the risk that these contracts would continue to result in additional margin calls that would further drain AIG’s cash.
Seven: Into the Fire
1 hardworking homeowners who were underwater: A home is “underwater” or has “negative equity” when the mortgage debt on the home exceeds its value.

The period when Rubin stood at the top of Wall Street and Washington was the age of inequality—hereditary inequality beyond anything the country had seen since the nineteenth century.
In his capacity as resident wise man, he urged Citigroup, as he had once urged Goldman Sachs, to take more trading risks with its huge balance sheet. He also advised that the risks needed to be carefully managed. After that, he didn’t pay much attention while, between 2003 and 2005, Citigroup tripled its issuing of collateralized debt obligations and mortgage-backed securities stuffed full of bad loans from places like Tampa, where people whose incomes had been flat for years had all their wealth in their houses and used them as cash machines. By late 2007, the bank had forty-three billion dollars in CDOs on its books.
Most of it turned out to be worthless, and in 2008, when the financial crisis hit, Citigroup practically became a ward of the state.

…

First, it represented a breakdown of the legal system. How else, other than unchecked fraud, could those banks have been “technically insolvent,” with only a handful of insiders knowing the truth? But there were deeper causes—the dismantling of the rules that had kept banking stable for half a century. Connaughton saw Kaufman—seventy years old, with a musty MBA from Wharton—as Rip Van Winkle, waking up in the age of “synthetic collateralized debt obligations” and “naked credit default swaps.” What the hell happened to Glass-Steagall, which maintained a wall between commercial and investment banking? (Passed by Congress in 1933, repealed by Congress in 1999, bipartisan vote, Clinton’s signature.) What about the “uptick rule,” which required investors to wait until a stock rose in price before selling it short? (Instated by the SEC in 1938, abolished by the SEC in 2007.)

…

The airlines were fucked, but not necessarily that much worse than after four terrible plane crashes. The Fed kept cutting rates. Before long, a financial boom was on.
In 2004, Kevin left his safe and boring job to join the proprietary trading desk at a big European bank, with zero job security and huge potential—one of the ballsier and more correct decisions of his life. The European bank was about to get into collateralized debt obligations. The stock market determined the size of your apartment and whether you had a Viking stove—who was rich and who wasn’t. The bond market determined if shit worked or everyone was eating sand, who was alive and who wasn’t. Ever since the eighties, credit had been the biggest driver. All the things that would later go wrong, structured credit, default swaps, were good inventions; they mitigated risk or offered financial solutions to companies and investors.

What he did not know was that Merrill Lynch, which had more than doubled its balance sheet to $1 trillion in assets over the previous two years, had been mortally wounded by the wipeout of the subprime mortgage market. O’Neal only tuned in to the problem in late July, after the implosion of two hedge funds run by a competing firm, Bear Stearns. The funds had been gigantic, multi-billion-dollar bets on collateralized debt obligations—CDOs, for short—which were securities constructed from subprime mortgages. Following the collapse of the Bear Stearns funds, other Wall Street firms, including Merrill Lynch, scoured their own balance sheets for any signs of exposure to the subprime market.
Then on August 9, 2007, a French bank, BNP Paribas, announced it would suspend the valuation of three subprime mortgage–based investment funds because liquidity in the market had disappeared.

…

On December 31, when the final numbers came in from the firm’s fixed-income trading division, the trading marks resulted in a nasty surprise: Merrill’s losses would be almost twice what his team had predicted just a month earlier.
There were two forces driving the increased losses. Like other large Wall Street investment banks, Merrill Lynch held hundreds of billions of dollars’ worth of assets on its balance sheet.
But the problem with Merrill Lynch’s balance sheet was that it contained more than $30 billion of collateralized debt obligations and billions more in other arcane investments, the underlying value of which was difficult to determine. The CDOs may have been worth an aggregate $30 billion at the time they were securitized, but there was no way they were still worth that amount.
As 2007 came to a close, the U.S. real estate market was in free fall. The epicenter was the subprime mortgage market, where unqualified buyers were walking away from mortgages underwritten by profligate lenders, particularly in such overheated markets as California, Arizona, Nevada, and Florida.

p. 254 ‘when the credit card took off’. Nocera, J. 1994. A Piece of the Action. Simon and Schuster. (That said, there is little doubt that finance is one area of human activity in which too much innovation can be a bad thing. As Adair Turner has put it, whereas the loss of the knowledge of how to make a vaccine would harm human welfare, ‘if the instructions for creating a CDO squared [a collateral debt obligation of collateral debt obligations] had somehow been mislaid, we will I think get along quite well without it.’) See Turner, A. 2009. ‘The Financial Crisis and the Future of Financial Regulation’. Inaugural Economist City Lecture, 21 January 2009. Financial Services Authority.
p. 254 ‘Lewis Mandell discovered’. Quoted in Nocera, J. 1994. A Piece of the Action. Simon and Schuster.
p. 254 ‘Michael Crichton once told me’.

The current problem is therefore much deeper than today’s conventional wisdom holds. Consider this typical example from a financial journal:
[Paul] Volcker is right. The collateralized debt obligations, collateralized mortgage-backed securities, and other computer-spawned complexities and playthings were not the solutions to basic needs in the economy, but to unslaked greed on Wall Street. Without them, banks would have had no choice but to continue to devote their capital and talents to meeting real needs from businesses and consumers, and there would have been no crisis, no crash, and no recession.”1
This describes only the most superficial level of a deeper problem of which the collateralized debt obligations (CDOs) and so forth are mere symptoms. The deeper problem was that there were insufficient “real needs” to which banks could devote their capital, because only those needs that will generate profits beyond the interest rate constitute valid lending opportunities.

If an unelected junta of bankers drafts America’s trade position, well, here’s the number to call.
And so the law of international finance became Lawlessness.
ATHENS
In May 2010, the end-game ended for Greece.
The new financial products were packaged, polished to a shine, and sold to government pension funds all over the planet. The bankers sold blind sacks of sub-prime mortgages, sliced and mixed up, as Collateralized Debt Obligations (CDOs) and other fetid concoctions. The Financial Services Agreement was rockin’!
But when opened, buyers found the bags were filled with financial feces. Government pensions and sovereign funds, from Finland to Qatar, lost trillions. The bags were toxic to bank balance sheets and several failed. However, in most cases, bankers could get a refill of capital juice from governments fearful of full-bore financial collapse.

…

The new President, Lula, resisted, despite the gun of bankruptcy threats in his face and the deals Brazil signed before he was sworn in. But Lula told the IMF to jam it and body-blocked privatizations, especially of the state-owned banks. Instead of begging international financiers for scraps, he opened the vaults of the state bank and lent out over half a trillion dollars for factories, farms, infrastructure—but not for one real for derivatives, hostile takeovers or collateralized debt obligations. During his two terms in office, Lula’s state banks gave their citizen-owners more credit than the IMF gave to over hun-dered nations. And Brazil’s economy went from the swamp to the stars.
Then Brazil struck oil, lots of it, in deep Atlantic waters. In the old days, that is, a decade ago, Chevron, Shell, and BP would have been onto those reservoirs like ticks, sucking up Brazil’s oil.

Good
risk management works with businesses to create the infrastructure
needed to support new products. Arguments about pricing, hedging,
and risking should take place before trading begins, not after.
JWPR007-Lindsey
234
May 7, 2007
17:9
h ow i b e cam e a quant
Adventures in CDO Land
Another incident shows the power and limitations of quantitative risk
management. A charismatic ex-derivatives trader started a CDO (collateralized debt obligation) business, which he ran as a derivatives business. The accounting was mark-to-market, and he acted as both the
structurer and the active manager of the portfolios of the underlying
portfolios of credits. A general problem for CDO structurers is that they
have to find buyers for all the tranches of a new structure at once in
order to launch the deal. My CDO trader neatly solved this problem;
he simply referenced unsold tranches of new deals into his previously
created CDOs!

More than 85 percent of the bonds received the highest grade from the rating agencies. Three years later over half of the mortgages would be delinquent and a quarter would be in foreclosure.24
None of this turmoil seemed to faze WaMu’s Capital Markets Group, which had ballooned to 200 employees, with offices in New York, Los Angeles, Chicago, and Seattle. The division presented plans to package and sell Collateralized Debt Obligations (CDOs), a type of security whose popularity had grown over the previous five years and which was even more complicated than a regular mortgage-backed security. CDOs were packaged with any kind of debt, causing the authors of a later book about the financial crisis to describe them as “asset-backed securities on steroids.”25 WaMu wanted to package its CDOs with home equity loans, credit card debt, and slices of mortgage-backed securities.

Wall Street firms eagerly filled the void. They bought the mortgages from brokers and other mortgage lenders and packaged them into mortgage-backed securities. Perversely, Fannie and Freddie were allowed to buy these, and acquired tens of billions of dollars in subprime-mortgage-backed securities to meet affordable housing goals set by Congress. The Wall Street firms also repackaged mortgage securities into collateralized debt obligations (CDOs) that allowed them to transmute even the dodgiest subprime mortgages into triple-A debt. The new derivatives called credit default swaps, which allowed CDO packagers and buyers to offload some of their risks, allowed for even more credit creation. Backing up all this packaging and repackaging and derivatization were options-theory-based risk models that were, of course, only as good as the information fed into them.